(This post is an excerpt from a recent TSI commentary.)

The stock market is not a machine that assigns prices based on a calm and objective assessment of value. In fact, when it comes to value the stock market is totally clueless.

This reality is contrary to the way that many analysts portray the market. They talk about the stock market as if it were an all-seeing, all-knowing oracle, but if that were true then dramatic price adjustments would never occur. That such price adjustments occur quite often reflects the reality that the stock market is a manic-depressive mob that spends a lot of its time being either far too optimistic or far too pessimistic.

The stock market can aptly be viewed as an emotion pendulum — the further it swings in one direction the closer it comes to swinging back in the other direction. Unfortunately, there are no rigid benchmarks and we can never be sure in real time that the pendulum has swung as far in one direction as it is going to go. There’s always the possibility that it will swing a bit further.

Also, the swings in the pendulum are greatly amplified by the actions of the central bank. Due to the central bank’s manipulation of the money supply and interest rates, valuations are able to go much higher during the up-swings than would otherwise be possible. Since the size of the bust is usually proportional to the size of the preceding boom, this sets the stage for larger down-swings than would otherwise be possible.

The following monthly chart of the Dow/Gold ratio (from Sharelynx.com) clearly shows the increasing magnitude of the swings since the 1913 birth of the US Federal Reserve.

In the real world there is money supply and there is money demand. There is no such thing as money velocity. “Money velocity” only exists in academia and is not a useful concept in economics or financial-market speculation.

As is the case with the price of anything, the price of money is determined by supply and demand. Supply and demand are always equal, with the price adjusting to maintain the balance. A greater supply will often lead to a lower price, but it doesn’t have to. Whether it does or not depends on demand. For example, if supply is rising and demand is attempting to rise even faster, then in order to maintain the supply-demand balance the price will rise despite the increase in supply.

When it comes to price, the main difference between money and everything else is that money doesn’t have a single price. Due to the fact that money is on one side of almost every economic transaction, there will be many (perhaps millions of) prices for money at any given time. In one transaction the price of a unit of money could be one potato, whereas in another transaction happening at the same time the price of a unit of money could be 1/30,000th of a car. This, by the way, is why all attempts to come up with a single number — such as a CPI or PPI — to represent the price of money are misguided at best.

If money “velocity” doesn’t exist in the real world, why do so many economists and commentators on the economy harp on about it?

The answer is that the velocity of money is part of the very popular equation of exchange, which can be expressed as M*V = P*Q where M is the money supply, V is the velocity of money, Q is the total quantity of transactions in the economy and P is the average price per transaction. The equation is a tautology, in that it says nothing other than the total monetary value of all transactions in the economy equals the total monetary value of all transactions in the economy. In this ultra-simplistic tautological equation, V is whatever it needs to be to make the left hand side equal to the right hand side. In other words, ‘V’ is a fudge factor that makes one side of a practically useless equation equal to the other side.

Another way to express the equation of exchange is M*V = nominal GDP, or V = GDP/M. Whenever you see a chart of V, all you are seeing is a chart of nominal GDP divided by some measure of money supply. That’s why a large increase in the money supply will usually go hand-in-hand with a large decline in V. For example, the following chart titled “Velocity of M2 Money Stock” shows GDP divided by M2 money supply. Given that there was an unusually-rapid increase in the supply of US dollars over the past 17 years, this chart predictably shows a 17-year downward trend in “money velocity”.

Note that over the 17-year period of downward-trending “V” there were multiple economic booms and busts, not one of which was predicted by or reliably indicated by “money velocity”. However, every boom and every bust was led by a change in the rate of growth of True Money Supply (TMS).

Chart source: https://research.stlouisfed.org/

In conclusion, “money velocity” doesn’t exist outside of a mathematical equation that, due to its simplistic and tautological nature, cannot adequately explain real-world phenomena.

Although it is not possible to determine an objective value for gold (the value of everything is subjective), by looking at how the metal has performed relative to other things throughout history it is possible to arrive at some reasonable conclusions as to whether gold is currently expensive, cheap, or ‘in the right ballpark’. In particular, gold’s market price can be measured relative to the prices of other commodities, the stock market, the price of an average house, the earnings of an average worker, and the real (purchasing-power-adjusted) money supply. In a recent TSI commentary I looked at the last of these, that is, I looked at gold’s price relative to the real money supply, and arrived at the conclusion that gold’s current price was about 20% above ‘fair value’. I’ll now take a look at gold relative to other commodities.

As illustrated below, over the past 20 years — with the exception of a short-lived spike in 2011 — major swings in the gold/silver ratio have bottomed at around 45 and peaked at around 80. The ratio is currently near the top of its 20-year range, which means that gold is expensive relative to silver.

As a consequence, to argue that there has been a successful long-term price suppression scheme in the gold market you must also argue that there has been a successful long-term price suppression scheme in the silver market. Such arguments have, of course, been put forward, with one analyst claiming that JP Morgan has managed to do the impossible by amassing a large long position in physical silver while simultaneously suppressing the price of silver by selling futures contracts.

The next chart shows that gold is also near a 20-year high relative to platinum, the implication being that gold is expensive relative to platinum.

Consequently, to argue that there has been a successful long-term price suppression scheme in the gold market you must also argue that there has been a successful long-term price suppression scheme in the platinum market. Again, such arguments have been put forward. For example, one analyst has suggested that the daily platinum ‘fix’ in the London market was used to manipulate the price downward over the long-term, even though there was an overall upward bias in the price over the period under analysis. For another example, an analyst has argued that the platinum price has been persistently reduced by the short-selling of platinum futures, an outcome that would only be plausible if every sale of a futures contract didn’t subsequently have to be closed-out via the purchase of a contract and if automotive companies had figured out a way to replace the physical platinum used in catalytic converters with paper contracts.

The final chart shows that gold is presently near an all-time high relative to the CRB Index (an index representing a basket of 17 commodities). This chart therefore shows that gold is expensive relative to commodities in general.

As far as I know, nobody has yet tried to argue that the prices of most commodities are being suppressed as part of a grand plan to conceal the long-term suppression of the gold price. Instead, gold’s expensiveness relative to commodities in general is studiously ignored.

To summarise the above: gold is currently expensive relative to many other commodities.

Almost regardless of what gold is measured against, it does not look cheap at this time. However, given what is happening to money and economies around the world, there is logic to the fact that gold is relatively expensive right now. Also, it is logical to expect that gold is going to get a lot more expensive within the next few years.

As I’ve explained in the past, gold is not now and has never been a play on “CPI inflation”. Of course, on a very long-term (multi-generational) basis the gold price will tend to rise by enough to offset the decline in the purchasing power of money, but so will the prices of many other assets. What makes gold special is that it is the premier long-term hedge against bad monetary and fiscal policies.

Gold isn’t cheap right now, but in a world that is rife with bad monetary and fiscal policies it is destined to become a lot more expensive.

Due to the confiscation of gold by the Roosevelt Administration in 1933, there remains an undercurrent of concern among gold owners that the US government or another major government will confiscate gold in the future. However, the risk of this happening is presently so low as to not be worth taking into account. Of far greater risk are capital controls and the confiscation of cash.

Gold confiscation is not a realistic threat under the current monetary system, because under the current system gold isn’t money. To further explain, the reason that gold was confiscated in the US in 1933 was that gold, at that time and place, was money, with the dollar essentially being a receipt for gold. Consequently, the amount of gold in the banking system placed a limitation on the quantity of dollars. By making gold ownership illegal the US government not only prevented the public from removing gold from the banking system, thus eliminating one of the superficial deflationary forces, it also pushed additional gold into the banking system and paved the way for greater monetary inflation.

Today, gold imposes no limitations on the abilities of the government and its agents to spend, borrow and inflate, so there is no reason for the government to confiscate it or even to care about it.

As an aside, in the 1930s the US government confiscated silver shortly after it confiscated gold, even though silver wasn’t official money at the time. However, the primary reason for the silver confiscation was the same as the reason for the gold confiscation — to pave the way for greater monetary inflation. As part of an effort to increase the money supply, the confiscated silver was put directly into the monetary base by turning it into legal tender in the form of coins or silver certificates. The 1934 silver nationalisation order actually brought silver back into the monetary system, where it remained until the early-1960s.

What the government wants to control is the official money, which in 1933 was gold and today is the dollar or some other fiat currency. The government is therefore focused on monitoring/controlling the flow of today’s currency units, which means that you are at far greater risk of having your cash confiscated or restricted in some way than having your gold confiscated.

Moreover, capital controls aren’t just a potential future problem, they exist in almost every country today. In almost every country there are already restrictions on a) the transfer of money across national borders, b) the transfer of money between different account-holders, and c) the amount of deposit currency that can be converted to physical cash. If these aren’t capital controls by another name, what are they?

Capital controls are likely to become more draconian over time. People with significant financial assets should therefore already be managing the capital-controls risk by diversifying their assets internationally*. Also, everyone (especially US citizens), including those who don’t yet have significant financial assets to protect, should have a second passport as a guard against future restrictions on freedom.

*If you are concerned about gold confiscation then you could also manage this risk by distributing your gold across vaults in different countries. This is easy to do via Bullionvault.com or the new BitGold service.