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1) Gold

2) The HUI

3) The Dollar Index

4) The S&P500 Index (SPX)

I last wrote about BitGold (XAU.V), which is now called Goldmoney, most recently in a blog post on 26th May. In the linked post I expanded on my view that the company had a great product from the perspective of customers, but a very over-priced stock. I concluded that at some unknowable future time the “it’s a great product with smart management therefore the stock should be bought at any price” bubble of enthusiasm would collide with the “it will always be a low-margin business and therefore deserves a low valuation” brick wall of reality. Although the stock price has since dropped about 20%, the valuation of the stock still appears to be extremely high considering the profit-generating potential of the underlying business. It is therefore fair to say that the bubble of enthusiasm hasn’t yet collided with the brick wall of reality.

Every month, Goldmoney reports what it calls “Key Performance Indicators” (KPIs) of its business. These KPIs seem impressive at first glance and seem to justify the stock’s market capitalisation. For example, the company reported that at the end of August it had C$1.5B of customer assets under management (AUM), an amount that is several times greater than its current market cap of C$235M (55M shares at C$4.27/share). However, unlike a mutual fund that charges a fee based on AUM, Goldmoney charges nothing to store its customers’ assets (gold bullion). This means that the larger the amount of Goldmoney’s AUM, the greater the net COST to the owners of the business (Goldmoney’s shareholders).

This is an important point. Based on Goldmoney’s current fee structure, it will always lose money on customers who use the service primarily for store-of-value purposes. Under the current monetary system this is where PayPal has a big advantage over Goldmoney. Nobody views their PayPal account as a long-term store of value, but many of Goldmoney’s customers view the service as a convenient way to store their physical gold. They don’t want to spend their gold, they want to save it.

Another KPI that looks impressive at first glance is “Transaction Volume”. For example, the company reported total transaction volume of C$47M for August. However, not all transactions attract fees and for the ones that do the fee is 1%. This means that the revenue to Goldmoney will always be less than 1% of the total transaction volume.

What’s important in assessing the stock’s valuation is the revenue to Goldmoney relative to its costs. This information is not presented in the company’s monthly KPI reports, but it is presented in the quarterly financial statements. Unfortunately, the latest quarterly statements aren’t useful because a major acquisition happened after the 30th June cutoff date. The next quarterly statements will be more informative, but we probably won’t get a good indication of Goldmoney’s real financial performance and earning potential until the December-quarter results are published early next year.

At this stage I don’t have enough information to value Goldmoney, although I suspect that ‘reasonable value’ is a long way below the current price. I’ll post some updated thoughts when I have a clearer view of what the stock is worth, which might not be until February next year. In the meantime I’ll stay away. I have no desire to own the stock and, despite the apparent valuation-related downside risk, no desire to short the stock.

I’ve placed a small bet (via put options) that the senior US stock indices will drop to test their 24th August lows by mid-October. At the same time I acknowledge the potential for a sharp move to the upside over the next 2-3 days in anticipation of and in reaction to the Fed’s 17th September interest-rate decision. That’s why my bearish bet is small.

The chart pattern of the S&P500 Index (SPX) suggests that there will be a sharp move over the days immediately ahead, although it doesn’t point to a particular direction. One possible outcome involves an upside breakout within the next two days from the contracting triangle drawn on the following chart and then a downward reversal. This is the near-term outcome that would confuse the greatest number of traders, which is why I favour it.

I never risk money on guesses about what any financial market is going to do over time periods as short as a few days, but it’s still fun to guess.

What I mean by the title of this post is that the central-bank tightening that almost always precedes an economic bust is never the cause of the bust. However, it’s a fact that economic busts are indirectly caused by policy mistakes, in that policy mistakes lead to artificial, credit-fueled booms. Once such a boom has been fostered, an ensuing and painful economic bust becomes unavoidable. The only question is: will the bust be short and sharp (the result if government and its agents stay out of the way) or drag on for more than a decade (the result if the government and its agents try to boost “aggregate demand”)?

The most commonly cited historical case of a policy mistake directly causing an economic bust is the Fed’s gentle tap on the monetary brake in 1937. This ‘tap’ was quickly followed by the resumption of the Great Depression, leading to the superficial conclusion that the 1937-1938 collapse in economic activity would never have happened if only the Fed had remained accommodative.

Let’s now take a look at what actually happened in 1937-1938 that could have caused the economic recovery of 1933-1936 to rapidly and completely disintegrate.

First, while commercial bank assets temporarily stopped growing in 1937, they didn’t contract. Commercial bank assets essentially flat-lined during 1937-1938 before resuming their upward trend in 1939.

Second, outstanding loans by US commercial banks were roughly the same in 1938 as they had been in 1936, so there was no widespread calling-in of existing loans. That is, there was no commercial-bank credit contraction to blame for the economic contraction.

Third, the volume of money held by the public was higher in 1937 than in 1936 and was roughly the same in 1938 as in 1937.

Fourth, M1 and M2 money supplies were roughly unchanged over 1937-1938, so there was no monetary contraction.

Fifth, the consolidated balance sheet of the Federal Reserve system was slightly larger in 1937 than in 1936 and significantly larger in 1938 than in 1937, so there was no genuine tightening of monetary conditions by the Fed at the time.

Sixth, an upward trend in commercial bank reserves that began in 1934 continued during 1937-1938.

Seventh, there were no increases in the interest rates set by the Fed during 1937-1938. In fact, there was a small CUT in the FRBNY’s discount rate in late-1937.

What, then, did the Fed do that supposedly caused one of the steepest economic downturns in US history? The answer is that it boosted commercial-bank reserve requirements.

All of which prompts the question: How did a 1937 increase in reserve requirements that didn’t even lead to a monetary or credit contraction possibly cause manufacturing activity to collapse and unemployment to skyrocket?

It’s a trick question, because the increase in reserve requirements clearly didn’t cause any such thing. The economic collapse of 1937-1938 happened because the recovery of 1933-1936 was not genuine, but was, instead, an artifact of increased government spending and other attempts to prop-up prices. The economy had never been permitted to fully eliminate the imbalances that arose during the late-1920s, so a return to the worst levels of the early-1930s was inevitable.

Many analysts are now worrying out loud that the Fed will repeat the so-called “mistake of 1937″, but the real problem is that the Fed and the government repeated the policy mistakes of the late-1920s and then repeated the policy mistakes of 1930-1936. The damage has been done and another economic bust is now unavoidable, regardless of what the Fed decides at this week’s meeting.