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

In a 12th June blog post I revisited the potential pitfalls in using sentiment as a market timing tool. As an example of a pitfall, the post included a chart of the Investors Intelligence (II) bull/bear ratio suggesting that US stock market sentiment had been consistent with a bull-market top for the bulk of the past four years. Even though the chart helped to make my point it is appropriate to question how sentiment, when used as a contrary indicator, could be so wrong for so long.

I’ve come up with a possible explanation for why measures of US stock-market sentiment that worked well as contrary indicators in the past have not been useful of late. The reason relates to the third of the potential pitfalls outlined in the above-linked blog post. Specifically:

“…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.”

The explanation I’ve come up with is that prior to the past few years the II sentiment survey, which is a survey of investment advisors who regularly publish their views via newsletters, reflected the sentiment of the investing public, but this is not so much the case anymore. Prior to the past few years the advisors and the general public would become increasingly bullish or increasingly bearish together, with high levels of optimism invariably following persistent price strength and high levels of pessimism invariably following either persistent or dramatic price weakness. Over the past few years, however, the perceptions of these two groups took separate paths. Investment advisors became very optimistic in reaction to the strong upward trend in prices, but for the most part the general public remained unenthusiastic about the stock market.

The change described above can be illustrated by comparing the II bullish percentage with the AAII (American Association of Individual Investors) bullish percentage, which has been done on the chart displayed below. The AAII survey is based on the opinions of retail investors, that is, the general public.

The chart shows that prior to 2014 the II (the blue line) and AAII (the black line) bullish percentages typically moved up and down together within a similar range, but that from 2014 onward the II bullish percentage tended to be significantly higher. Furthermore, the distance between the two survey results has increased since early this year, with the II bullish percentage remaining above 50 and the AAII bullish percentage spending most of its time in the 25-35 range. The most recent results show an II bullish percent of 54.9 and an AAII bullish percent of 29.7.

It seems that the general public’s stock-market sentiment has not reached an optimistic extreme during the current cycle. Does this mean that there’s a lot more price strength to come or does it mean that the next major price top will happen without the general public having fully embraced the upward trend?

I don’t know, but it’s definitely possible that the public will never fully embrace the latest bullish trend for the simple reason that it is financially incapable of doing so. Having had its savings decimated when earlier Fed-fueled investment booms inevitably collapsed it may not have the financial wherewithal to enthusiastically participate in the Fed’s latest bubble-blowing venture.

A 23rd June post at the TSI Blog described the model (the Gold True Fundamentals Model – GTFM) that I developed to indicate the extent to which the fundamental backdrop is bullish for gold. The GTFM is an attempt to determine a single number that incorporates the most important fundamental drivers of the gold price, where I define “fundamental driver” as something that happens in the economy or the financial markets that causes a significant change in the desire/urgency to own gold in some form. Keith Weiner subsequently posted an article objecting to some of my “fundamental drivers”, which would be fine except that his article contains several misunderstandings of these price drivers and/or how I am using them. The purpose of this post is to address these misunderstandings and provide a little more information on the GTFM’s components.

1. The ‘Real’ Interest Rate

Keith states: “The Real Interest Rate is the Nominal Interest Rate – inflation.” No, that’s not what the real interest rate is, although many people wrongly calculate it that way.

Keith and I agree that it is not possible to calculate the economy-wide change in money purchasing-power (PP), but even if it were possible to come up with a single number that represented prior “inflation” the real interest rate would not be the nominal interest rate minus this number. The reason, to explain using an example, is that the real return that will be obtained by someone who makes a 12-month investment today in an interest-bearing security will have nothing to do with the change in the PP of money over the preceding 12 months. Instead, the real return that will be obtained by this person will be determined by the change in money PP over the ensuing 12 months.

Now, we can obviously never know in advance what the real return on any interest-bearing security or deposit will be, but since the advent of Treasury Inflation-Protected Securities (TIPS) in 2003 it has been possible to roughly determine the real return on Treasury debt expected by the average bond trader. The TIPS yield, which is based on the EXPECTED rate of currency depreciation, is my ‘real’ interest rate proxy.

If there had been a TIPS market in the 1970s then it would probably be apparent that the large gains made by the gold price during that decade were related to a low/falling real interest rate, where the real interest rate is defined as the nominal interest rate minus the expected rate of currency depreciation. In any case, there has definitely been an inverse correlation between the TIPS yield (10-year or 5-year) and the gold price over the past 10 years. Furthermore, the correlation has strengthened over the past 2 years.

By the way, it’s the DIRECTION, not the value, of the TIPS yield that matters to gold and that is taken into account by the GTFM.

The inverse relationship between the TIPS yield and the gold price is far from perfect, the reason being that there are times when other price drivers are more influential. That’s why the ‘real interest rate’ has only a one-seventh weighting in the GTFM.

2. The Yield Curve

There has never been a strong and consistent short-term correlation between the gold price and the yield curve, but near major turning points the yield curve tends to be the dominant driver.

In broad terms, the boom phase of the central-bank-promoted boom-bust cycle is generally associated with a flattening yield curve and the bust phase is generally associated with a steepening yield curve. Gold generally performs better during the bust phase, when the curve is steepening. Somewhat counterintuitively, banks tend to do best during the long periods of yield-curve flattening. This can be demonstrated empirically and makes sense if you understand how the central-bank-promoted boom-bust cycle works.

A major flattening trend in the US yield curve got underway during the second half of 2011 and continues to this day. This flattening trend is associated with a boom, which, in turn, has temporarily helped the banks and reduced the desire to own gold.

3. Credit Spreads

The trend in credit spreads is one of the best measures of the overall trend in economic confidence, with widening spreads (yields on lower-quality bonds rising relative to yields on higher-quality bonds) being indicative of declining economic confidence. Gold tends to do relatively well during periods when economic confidence is on the decline, that is, during periods when credit spreads are widening. I have demonstrated this in the past using charts.

4. The Relative Strength of the Banking Sector

Keith writes: “We haven’t plotted it, but we assume bank stocks will outperform the broader stock market when the yield curve is steeping by way of falling Fed Funds rate. This is when the banks’ net interest margin is rising, and they are getting capital gains on their bond portfolio too. At the same time, credit spreads are narrowing, so the banks are getting capital gains on their junk bonds.”

No, that’s not how it works. Refer to my yield curve comments above for a very brief explanation.

The banking sector will often fare poorly during major yield-curve steepening trends because a banking crisis is often a primary cause of the steepening trend. In any case, this indicator is based on the concept that the investment demand for gold will be boosted by declining confidence in the banking system and reduced by rising confidence in the banking system.

5. The US Dollar’s Exchange Rate

More often than not, the US$ gold price trends in the opposite direction to the Dollar Index. However, there are times when a crisis outside the US causes both a rise in the US$ on the FX market and a large rise in the US$ gold price. The fact that the inverse correlation between the gold price and the Dollar Index can break down in a big way at times is why the US dollar’s performance on the FX market only has a one-seventh weighting in the GTFM. To put it another way, if the gold price always moved in the opposite direction to the Dollar Index then there would be no reason for gold traders to consider anything except the Dollar Index.

6. The General Trend in Commodity Prices

I have included the general trend in commodity prices as indicated by the S&P GSCI Commodity Index (GNX) in the GTFM for the practical reason that there are times when it tips the balance. That is, there are times when a strong upward trend in commodity prices enables the US$ gold price to rise despite an otherwise slightly-bearish (for gold) fundamental backdrop and there are times when a strong downward trend in commodity prices causes the US$ gold price to fall despite an otherwise slightly-bullish fundamental backdrop.

7. The Bond/Dollar Ratio

There are fundamental reasons for the existence of a positive correlation between the bond/dollar ratio (the T-Bond price divided by the Dollar Index) and the US$ gold price, but I currently don’t have the time or the inclination to go into these reasons. Instead, for the sake of brevity I present the following chart-based comparison of the gold price and the bond-dollar ratio. The positive correlation is obvious and is evident over much longer periods than the 3-year period covered by this chart.

I hope the above goes at least part of the way towards explaining the components of my gold model.

[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).

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.

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 Yardeni.com 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.

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.

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)

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.

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.

[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.

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.

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.

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.

Governments and central banks have invoked the writings of J.M. Keynes to justify the massive increases in government spending and monetary inflation that have occurred over the past 9 years. However, some of Keynes’s apologists have pointed out that the famous British economist would not have agreed with many of the policy responses for which his work has provided the intellectual justification. They point out, for example, that Keynes only advocated temporary increases in government spending as a means of absorbing shocks to the economy, and that he was dead against currency debasement and the creation of structural deficits. The problem, though, isn’t that Keynes’s theory has been applied to an unreasonable extreme; the problem is that the theory is completely wrong.

For starters, the laws of economics always apply, so if greater government deficit-spending really did act to strengthen the economy during recessions then it would also act to strengthen the economy during the good times. On the other hand, if greater government deficit-spending hurt the economy during the good times then it would also hurt the economy during recessions. The point is that there isn’t one set of laws that applies during periods of growth and another set that applies during periods of contraction.

Secondly, the concept that the government can provide a sustainable boost to the economy by increasing its spending is based on the fallacy that increased consumer spending causes the economy to grow. It causes GDP to increase due to the misleading way the GDP calculation is done, but for an increase in consumer spending to be sustainable it must be an effect of real growth; that is, it must follow an increase in production, which, in turn, must follow an increase in saving. Consumer spending is the caboose, not the engine.

Thirdly and as most people realise, the government usually does things much less efficiently than the private sector. The fact is that government spending tends to involve a lot of wastage. This is not an issue for the true Keynesian because he views an increase in spending as an economic plus even if the spending is totally unproductive, but it should be an issue for a good economist.

Fourthly, the government doesn’t generate any real wealth of its own that can be spent in order to offset what’s happening in the private sector. Instead, everything the government spends must first be borrowed or stolen from the private sector. So, how can the private economy possibly be helped by the government increasing the rate at which it steals and borrows from the private sector?

Fifthly, recessions occur because of the widespread mal-investment prompted by the earlier expansions of the supplies of money and unbacked credit brought about by the central bank and the commercial banks. As a result of this mal-investment, the economy’s structure becomes distorted such that it is geared to produce too much of some things and not enough of others. Unfortunately, the Keynesians mislabel the distortion caused by inflation as an “output gap”, which they then cite as justification for more inflation and more government spending. To further explain, recessions are symptoms of the process via which an economy attempts to rid itself of the distortions caused by prior inflation and intervention. And yet, in its role as “economic shock absorber”, the central-planning team comprising the government and the central bank tries to sustain the distortions. How can this possibly be beneficial?

If an economy is strong enough it should be able to recover DESPITE the application of Keynesian remedies designed to smooth-out the transition to the next expansion, which is why the economy usually recovers. However, the economic structure will necessarily be weakened by each successive increase in government spending and each successive monetary-inflation-fueled boom until, eventually, the economy will be in such a weakened state that it will be unable to bounce back in the face of more Keynesian policies. That’s why the US economy’s recovery from the 2007-2009 recession has been ‘surprisingly’ lacklustre and why Japan’s economy now seems incapable of strong growth.

Hyperinflation* and/or a totalitarian state are the inevitable destinations if Keynes’s theories are relentlessly applied over the long term. The reason is that each round of policy mistakes creates the justification for more mistakes, setting in motion a downward spiral that will be inescapable as long as the perceived solution entails more of the same. The only unknown is how long it will take to reach one or both of these destinations.

*Just to be clear and as explained in a previous blog post, I have never been of the view that hyperinflation is an imminent threat to the US economy. The imminent threat is the continuing erosion of freedom as new interventions by the government are justified by the adverse consequences of earlier interventions.

The price of gold is dominated by investment demand* to such an extent that nothing else matters as far as its price performance is concerned. Investment demand is also the most important driver of silver’s price trend, although in silver’s case industrial demand is also a factor to be reckoned with. In addition, changes in mine supply have some effect on the silver market, because unlike the situation in the gold market the annual supply of newly-mined silver is not trivial relative to the existing aboveground supply of the metal.

Given that the change in annual mine supply is irrelevant to the gold price and is not close to being the most important driver of the silver price, why do some analysts argue that the gold/silver ratio should reflect the relative rarities of the two metals in the ground and therefore be 10:1 or lower? I don’t know, but it isn’t a valid argument.

A second way of using relative rarity to come up with a very low gold/silver ratio is to assert that the price ratio should be based on the comparative amounts of aboveground supply. Depending on how the aboveground supplies are calculated, this method could lead to the conclusion that silver should be more expensive than gold. It would also lead to the conclusion that gold should be the cheapest of all the world’s commonly-traded metals, instead of the most expensive. For example, if gold’s relatively-large aboveground supply was a reason for a relatively low gold price then gold should not only be cheaper than silver, but also cheaper than copper.

Another argument is that the gold/silver ratio should be around 16:1 because that’s what it averaged for hundreds of years prior to the last hundred years. This is also not a valid argument, because changes in technology and the monetary system can cause permanent changes to occur in the relative values of different commodities and different investments. For example, when monetary inflation was constrained by the Gold Standard the stock market’s average dividend yield was always higher than the average yield on the longest-dated bonds, but the 1934-1971 phasing-out of the official link to gold permanently altered this relationship. In a world where commercial and central banks can inflate at will, the stock market will always yield less than the bond market (except when the central-bank leadership goes completely ‘off its rocker’ and implements the manipulation known as NIRP). This is because stocks have some built-in protection against inflation. The point is that the ratio of gold and silver prices during an historical period in which both metals were officially “money” does not tell us what the ratio should be now that neither metal is officially money and one of the markets (silver) has a significant industrial demand component.

The global monetary system’s current configuration dates back to the early 1970s, when the last remaining official link between gold and the US$ was severed. This probably means that we can look at how gold and silver have performed relative to each other since the early 1970s to determine what’s normal and what’s possible. With reference to the following chart, here’s a summary of what happened during this period:

a) The gold/silver ratio spent the bulk of the 1970s in the 30-40 range, but broke out of this range to the downside during the second half of 1979 in response to massive accumulation of silver bullion and silver futures by the Hunt brothers.

b) The ratio dropped as low as 16:1 in January of 1980, but then returned to 40 in the ‘blink of an eye’ as rule changes by the commodity exchange created financial problems for the highly-geared Hunts and a commodity-investment bubble began to deflate.

c) During the second half of the 1980s the ratio trended upward as US financial corporations weakened. The ratio peaked at around 100 at the beginning of 1990s in parallel with a full-blown banking crisis that almost resulted in the collapse of some of the largest US banks.

d) The ratio trended lower throughout the 1990s as the banks recovered (with the help of the Fed) and financial assets trended upward.

e) From the late 1990s through to the beginning of 2011 the ratio oscillated between 45 and 80, with 80 being reached near the peaks of financial crises (early-2003 and late-2008) and 45 being reached in response to generally high levels of economic confidence.

f) In February of 2011 the ratio broke below the bottom of its long-term range and rapidly moved down to around 30. The huge price run-up in silver that led to this large/fast decline in the gold/silver ratio was fueled by the overt bullishness of a high-profile/well-heeled speculator (Eric Sprott) and by various rumours, including rumours of silver shortages and the unwinding of a price-suppression scheme led by JP Morgan. There were no silver shortages and there was no price-suppression scheme to be unwound, but as is often the case in the financial markets the facts didn’t get in the way of a good story.

g) The 2010-2011 parabolic rise in the silver price ended the same way that every similar episode in world history ended — with a price collapse.

h) Silver’s Q2-2011 price collapse set in motion a major, multi-year upward trend in the gold/silver ratio. In this case, the upward trend in the ratio was driven by the deflating of a commodity investment bubble and problems in the European banking industry. The ratio rose all the way to the low-80s and is still at an unusually-high level in the 70s.

The gold/silver ratio’s performance over the past five decades suggests that the 45-60 range can now be considered normal, with moves well beyond the top of this range requiring a banking crisis and/or bursting bubble and moves well beyond the bottom of this range requiring rampant speculation focused on silver.

*In this post I’m lumping speculative, safe-haven and savings-related demand together under the term “investment demand”.

The short answer to the above question is that they are neither. Read on for the longer answer.

Consider what happened to nominal interest rates during the long-term gold bull markets of the past 100 years. Interest rates generally trended downward during the gold bull market of the 1930s, upward during the gold bull market of the 1960s and 1970s, and downward during the bull market of 2001-2011. History’s message, therefore, is that the trend in the nominal interest rate does not strongly influence gold’s long-term price trend.

History tells us that gold bull markets can unfold in parallel with rising or falling nominal interest rates, but this shouldn’t be interpreted as meaning that interest rates don’t affect whether gold is in a bullish or bearish trend. The long-term trend in the nominal interest rate is not critical; what is of great importance, as far as the gold market is concerned, is the REAL interest rate, with low/falling real interest rates being bullish for gold and high/rising real interest rates being bearish. For example, when gold was making huge gains during the 1970s in parallel with high/rising nominal interest rates, real interest rates were generally low. This is because gains in inflation expectations were matching, or exceeding, gains in nominal interest rates (the real interest rate is the nominal interest rate minus the EXPECTED rate of currency depreciation).

Very low real interest rates are artifacts of central banks, because in an intervention-free market all lenders would insist on a significant real return in exchange for temporarily relinquishing control of their money. In other words, “very low real interest rates” essentially means “very loose monetary policy”.

Something else that affects gold’s price trend is the difference between long-term and short-term interest rates (the yield-spread, or yield curve), with a rising yield-spread (‘steepening’ yield curve) being bullish for gold and a falling yield-spread (flattening yield curve) being bearish. It works this way because a rising trend in long-term interest rates relative to short-term interest rates generally indicates either falling market liquidity (associated with increasing risk aversion and a flight to safety) or rising inflation expectations, both of which are bullish for gold.

As is the case with the real interest rate, under the current monetary system the yield-spread tends to be a symptom of what central banks are doing. If money were free of central bank manipulation then the yield-spread would spend most of its time near zero (the yield curve would be almost horizontal) and would experience only minor fluctuations, but thanks to the attempts by central banks to ‘stabilise’ the financial world the yield-spread experiences the huge swings shown on the chart included below.

Last but not least, gold is influenced by the economy-wide trend in credit spreads (the differences between interest rates on high-quality and low-quality debt securities). Gold, a traditional haven in times of trouble, tends to do relatively well when credit spreads are widening and relatively poorly when credit spreads are contracting.

In summary, gold benefits from low real interest rates, an increasing yield-spread (a steepening yield curve), and widening credit spreads, each of which can occur when nominal interest rates are rising or falling.

Many commentators like to speculate on where the dollar-denominated gold price is ultimately headed. Some claim that it is destined to reach $3,000/oz, others claim that it won’t top until it hits at least $5,000/oz, and some even forecast an eventual rise to as high as $50,000/oz. All of these forecasts are meaningless.

Long-term dollar-denominated price targets are meaningless because a) they fail to account for — and cannot possibly account for, since it is unknowable — the future change in the dollar’s purchasing power, and b) the only reason a rational person invests is to preserve or increase purchasing power. To further explain by way of a hypothetical example, assume that five years from now a US dollar buys only 20% of the everyday goods and services that it buys today. In this case, the US$ gold price will have to be around $6,500/oz just to maintain its current value in purchasing power terms. To put it another way, in my example a person who buys gold at around $1300/oz today and holds it will suffer a loss, in real terms (the only terms that matter), unless the gold price is above $6,000/oz in April-2022. Considering a non-hypothetical example to make the same point, in 2007-2009 a resident of Zimbabwe who owned a small amount of gold and not much else would have become a trillionaire in Zimbabwe dollars and would also have remained poor.

The purchasing power issue is why the only long-term forecasts of gold’s value that I ever make are expressed in non-monetary terms. For example, throughout the first decade of this century I maintained that gold’s long-term bull market would continue until the Dow/gold ratio had fallen to at least 5 and would potentially continue until Dow/gold fell to 1.

The 2011 low of 5.7 in the Dow/gold ratio wasn’t far from the top of my expected bottoming range, although I doubt that the long-term downward trend is over. In any case, none of the buying/selling I do this year will be based on the realistic possibility that the Dow/gold ratio will eventually drop to 1. Such long-term forecasts are of academic interest only, or at least they should be.

If I were forced to state a very long-term target for the US$ gold price, it would be infinity. The US$ will eventually become worthless, at which point gold will have infinite value in US$ terms. But then, so will everything else that people want to own.

Gold is probably immersed in a multi-decade bull market containing cyclical bull and bear markets. We can be sure that a cyclical bear market began in 2011, but did this bear market come to an end in December of 2015? In other words, did a new cyclical gold bull get underway in December-2015? I don’t know, but the point I want to make today is that the answer to this question is not as important as most gold-market enthusiasts think.

During the first half of 2016 my view was that although a new cyclical gold bull market had probably begun, it was far from a certainty. The main reason I had some doubt was that gold’s true fundamentals* were not decisively bullish. However, by November of last year I thought it likely that a new gold bull market had NOT begun in December-2015. This was mainly because the true fundamentals had collectively become almost as gold-bearish as they ever get. It was also because it had, by then, become crystal-clear that the US equity bull market did not end in 2015.

The cyclical trend in the US stock market is important for gold. During any given year the gold price and the US stock market (as represented by the S&P500 Index) are just as likely to move in the same direction as move in opposite directions, but over long periods they are effectively at opposite ends of a seesaw. As far as I can tell, it would be unprecedented for a cyclical gold bull market to begin when a cyclical advance in the US stock market is far from complete.

In any case, for practical speculation purposes there is never a need to answer the question: bull market or bear market? In fact, there is never a need to even ask the question. The question that should always be asked is: based on all the relevant evidence at the current time, should I buy, sell or do nothing?

For example, based on the extreme negativity that prevailed at the time, the length and magnitude of the preceding price decline and a number of other considerations, it could be determined in January-2016 that an excellent opportunity to buy gold-mining stocks had arrived. Coming to this conclusion did not require having an opinion on whether a new gold bull market was getting underway. For another example, during May-August of last year an objective assessment of the price action and the important sentiment indicators revealed numerous excellent opportunities to reduce exposure to the gold-mining sector, regardless of whether or not a new bull market had begun several months earlier. For a third example, the analysis of the salient evidence in real time during December of last year suggested that another sector-wide buying opportunity had arrived in the world of gold mining. Again, taking advantage of this buying opportunity did not require an opinion on whether a cyclical gold bull market had begun back in December-2015.

The upshot is that assertions to the effect that an investment is in a bull market or a bear market can make for colourful commentary, but in the real worlds of trading and investing it’s best not to get hung up on bull and bear labels. As well as being unnecessary, fixating on such labels can be problematic. This is because someone who is convinced that a bull market is in progress will be inclined to ignore good selling opportunities and someone who is convinced that a bear market is underway will be inclined to ignore good buying opportunities.

*In no particular order, the fundamental drivers of the US$ gold price are the real US interest rate (as indicated by the 10-year TIPS yield), US credit spreads, the relative strength of the US banking sector (as indicated by the BKX/SPX ratio), the US yield curve, the general trend in commodity prices and the US dollar’s performance on the FX market (as indicated by the Dollar Index).

The article “What sets the Gold Price — Is it the Paper Market or Physical Market?” contains some interesting information about the gold market and is worth reading, but it also contains some logical missteps. In this post I’ll zoom in on a couple of the logical missteps.

The following two paragraphs from near the middle of the above-linked article capture the article’s theme and will be my focus:

“In essence, trading activity in the London gold market predominantly represents huge synthetic artificial gold supply, where paper gold trading is deriving the price of gold, not physical gold trading. Synthetic gold is just created out of thin air as a book-keeping entry and is executed as a cashflow transaction between the contracting parties. There is no purchase of physical gold in such a transaction, no marginal demand for gold. Synthetic paper gold therefore absorbs demand that would otherwise have flowed into the limited physical gold supply, and the gold price therefore fails to represent this demand because demand has been channelled away from physical gold transactions into synthetic gold.

Likewise, if an entity dumps gold futures contracts on the COMEX platform representing millions of ounces of gold, that entity does not need to have held any physical gold, but that transaction has an immediate effect on the international gold price. This has real world impact, because many physical gold transactions around the world take this international gold price as the basis of their transactions.”

The most obvious error in the above excerpt concerns the effect of ‘dumping’ gold futures contracts on the COMEX. While this action could certainly have the immediate effect of pushing the gold price down, the short-sale of a futures contract must subsequently be closed via the purchase of a futures contract. This means that there can be no sustained reduction in the gold price due to the selling of futures contracts.

A related error is one of omission, since the gold price is often boosted by the speculative buying of futures contracts. Again, though, the effect will be temporary, since every purchase of a futures contract must be followed by a sale.

With regard to the massive non-futures paper gold market, the existence of such a market is a consequence of gold’s unique role in the commodity world. Whereas the usefulness of other commodities stems from the desire to consume them in some way, gold is widely considered to be at its most useful when it is sitting dormant in a vault. This means that to get the benefit of owning gold a person doesn’t necessarily need physical access to the gold. In many cases, a paper claim to gold sitting in a vault on the other side of the world will be considered as good as or better than having the physical gold in one’s possession. Furthermore, in many cases a piece of paper that tracks the price of gold will be considered as good as a paper claim to physical gold in a vault.

At the same time, there will be people who want ownership of physical gold — either gold in their own possession or a receipt that guarantees ownership of a specific chunk of metal stored in a vault. The gold demand of such people could not be satisfied by a piece of paper that tracked the gold price and was settled in dollars or some other currency. In other words, demand for physical gold could not be satisfied by the creation of so-called “synthetic artificial” gold.

The reality is that the existence of the massive non-futures-related “paper” gold market effectively results in a lot more gold supply AND a lot more gold demand than would otherwise be the case. To put it more succinctly, it results in a much bigger and more liquid market. This, in turn, makes it more feasible for large-scale speculators to get involved in the gold market and would not necessarily result in the gold price being lower than it would be if trading were limited to physical gold.

On a related matter, there is not a massive non-futures paper market in platinum and yet the platinum price is close to a 50-year low relative to the gold price. Also, the general level of commodity prices, as represented by the GSCI Spot Commodity Index (GNX), made an all-time low relative to gold last year. If the “paper” market is suppressing the gold price, why has gold become so expensive relative to most other commodities?

I view the whole paper-physical debate as a distraction from the true drivers of the gold price. The fact is that gold’s price movements can best be understood by reference to ‘real’ interest rates, currency exchange rates, and indicators of economic and financial-system confidence — what I refer to as gold’s true fundamentals. For example and as illustrated by the following chart, the bond/dollar ratio does a good job of explaining gold’s price trends most of the time.

In conclusion, the “paper” gold market is not a problem to be reckoned with. It is just part of the overall gold situation and, as noted above, a consequence of gold’s historical role. Moreover, it isn’t going anywhere, so it makes no sense to either complain about it or base a bullish view on its disappearance.

The answer to the above question is no, but it’s a trick question. Value is subjective and therefore can’t be stored, meaning that there is no such thing as a store of value. An ounce of gold, for instance, will be valued differently by different people. It will also be valued differently by the same person in different situations. For example, you might value gold highly in your present situation, but if you were stranded alone on an island with no hope of rescue then gold would probably be almost worthless to you. Rather than asking if gold is a good store of value it is more sensible to ask if gold is a good store of purchasing power in a modern economy, but this question does not have a one-word answer. It has a “yes, but…” answer.

Gold has been a good store of purchasing power in the past, but only reliably so when the initial purchase was made at a ‘reasonable’ price and the time period in question was extremely long. What I mean is that you can’t pay a ridiculously-high amount for an ounce of gold and reasonably expect the ounce to retain its purchasing power, even if the planned holding period is several decades. I also mean that if you buy gold at a time when it is being valued at a relatively moderate level you will be at risk of suffering a loss of purchasing power unless you are prepared to hold for decades.

Now, it’s not possible to come up with a single number that reflects the economy-wide change in the purchasing power of any currency, but by considering the change in the US$ gold price over time and making some basic assumptions about the change in the US dollar’s purchasing power we can get some idea of how gold’s purchasing power has shifted. Here are some examples.

First, from its September-2011 peak to its December-2015 bottom the US$ gold price fell by about 45%. There’s no way of calculating the change in the US dollar’s purchasing power over this period (the official CPI and all unofficial CPIs are bogus), but we can be certain that the US$ lost purchasing power. We can therefore be sure that gold lost more than 45% of its purchasing power over this roughly-4-year period.

Second, from its January-1980 peak to its February-2001 bottom the US$ gold price fell by about 70%. Again, there’s no way of calculating the change in the US dollar’s purchasing power over this period, but we can be certain that the US dollar’s purchasing power was much lower in February-2001 than it was in January-1980. We can therefore identify a 21-year period during which gold lost substantially more than 70% of its purchasing power.

Third, anyone who bought gold near the January-1980 top (37 years ago) and held to the present day would still not be close to breaking even in purchasing-power terms, even though the nominal price is now about 50% higher. Moreover, it’s conceivable that buyers of gold near the top in January-1980 will never break even in purchasing-power terms, regardless of how long they hold.

Fourth, by making the same type of rough-but-realistic assumptions about changes in the US dollar’s purchasing power it can be established that there were two periods of 8-10 years over the past 5 decades when there were huge increases in gold’s purchasing power.

The point is that when gold is not money (the general medium of exchange) it tends NOT to maintain its purchasing power over what most people would consider to be a normal investment timeframe. Instead, gold’s purchasing power tends to experience massive swings. By being knowledgeable and unemotional you can take advantage of these swings. What you can’t reasonably expect to do is conserve your purchasing power by mindlessly buying gold at any price.