According to the fellow in the video shown below, the Chinese are invading Australia. It isn’t a military invasion, it’s an economic invasion that involves the buying-up of Australian real estate and has caused young Australian families to be priced out of the property market. The solution, apparently, is for the Australian federal government to stop turning a blind eye to this flood of foreign investment and, instead, to put a stop to it, thus resuscitating the “Australian dream”. Unfortunately, the star of the video is both ethically and economically wrong. He is ethically wrong because he is advocating the widespread violation of property rights (he wants the government to dictate who Australian property owners can sell to, with the particular aim of preventing the sale of property to buyers who live in China), but it’s the economic error I’m going to deal with in this post.

Our ‘the-government-oughta-do-something-to-stop-the-Chinese-real-estate-invasion’ protest organiser and You-Tuber is unaware of two important economic realities, the first and lesser important of which is that Australia runs a large current-account deficit. This deficit, which comprises dividend payments, interest payments on foreign debt and a surplus of imports over exports, is running at around A$40B per year. This means that about $40B per year is ‘flowing’ out of the country on the current account, which means that about $40B/year of new investment MUST flow into the country (since nobody has any use for Australian dollars outside Australia). In other words, the current account deficit necessitates $40B per year of net foreign investment, approximately a quarter of which goes into real estate.

The more important economic reality of which our irrepressible video presenter is unaware is Australia’s rapid rate of monetary inflation. Thanks to the activities of the Reserve Bank of Australia (RBA) and the commercial banks, the supply of Australian dollars has risen by 13% over the past 12 months and 44% over the past 4 years. With this rate of money-supply growth and low interest rates it is no wonder that houses have become very expensive. With this monetary backdrop, houses would almost certainly have become very expensive even if China didn’t exist. Furthermore, a rapid rate of monetary inflation tends to increase the current account deficit and weaken the currency on the foreign exchange market, thus putting more of the currency in the hands of foreign investors and simultaneously making domestic property prices look cheaper to foreign investors.

So, if the guy in above video had a better understanding of economics he’d be organising a protest outside the RBA headquarters instead of the Chinese consulate.

The title of this post refers to the debate between Jeff Clark and Harry Dent about gold’s prospects over the next 2 years, with Harry Dent arguing for a collapse in the gold price to less than $700/oz and Jeff Clark arguing in favour of a bullish outcome. I put inverted commas around the word great, because neither participant in this debate made a good argument. However, while the Clark side of the debate could have been a lot better, the Dent side was a stream of complete nonsense. In this post I’ll deal with a couple of the flaws in Dent’s analysis and also briefly address the extremely persistent deflation fantasy that lies at the core of Dent’s latest big prediction*.

An important point to understand is that gold is not now, and has never been, a play on “CPI inflation”. As I stated in an earlier post: “Gold is a play on the economic weakness caused by bad policy and on declining confidence in the banking establishment (led by the Fed in the US). That’s why cyclical gold bull markets are invariably born of banking/financial crisis and/or recession, and why a cyclical gold bull market is more likely to begin amidst rising deflation fear than rising inflation fear.” Jeff Clark barely touches on this key point, while Harry Dent believes that the point is invalidated by the fact that the gold price fell by 33% during part of the 2008 financial crisis.

Harry Dent keeps returning to gold’s performance during 2008 and provides no other historical examples of gold performing poorly in times of financial crisis. He therefore either has very little knowledge of gold’s historical record or he believes that hundreds of years of history were negated by what happened during 2008. Either way, he is misinformed, because gold outperformed the US$ over the course of 2008. The 33% decline is from the best level of the year to the worst level of the year, but even this sizeable peak-to-trough loss was fully eradicated by the first quarter of 2009. Moreover, if we consider the entire Global Financial Crisis (GFC), with the 10th October 2007 closing high for the S&P500 marking its beginning and the 10th March 2009 closing low for the S&P500 marking its end, we find that gold gained 24% in US$ terms and 34% in euro terms over the course of the crisis.

Information that must always be taken into account when assessing gold’s performance in reaction to events is the gold-price starting point. The reason that gold was initially hit hard in US$ terms during the general market crash of 2008-2009 is largely due to the US$ gold price being ‘overbought’ and at a multi-decade high just prior to the crash, which is obviously not the case today. Furthermore, as I mentioned above it quickly recouped its losses.

And information that must be taken into account when assessing the performances of all the financial markets during the GFC of 2007-2009 is that the Fed did not begin to pump-up the US money supply (properly measured via TMS) until September of 2008. From September of 2007 through to August of 2008 the Fed cut interest rates, but the monetary inflation rate remained at a low level. Since there is no longer any scope to cut interest rates, it’s a virtual certainty that the Fed’s initial response to a deflation scare in the not-too-distant future would involve ramping-up the money pumps.

In addition to presenting gold’s GFC performance in a misleading way, there are numerous problems with Dent’s argument. Due to time constraints I’m only going to deal with one of them. Here’s the relevant excerpt:

“The gold bug camp is constantly telling us that governments are debasing our currency, especially the almighty US dollar and destroying the value so that the dollar is not a good store of value. I 100% disagree.

Here’s an analogy to explain: Since its invention in 1971, the microchip has been multiplied by the trillions, creating a revolution in human communications. Its evolution is a crystal-clear sign of progress and of a higher standard of living. Translating that back to the dollar argument, if the exponential multiplication of the microchip was (is) a good thing, why would the multiplication of dollars not also be a sign of progress that similarly fosters a revolution in urbanization, more complex and rich specialization of skills, and an improved standard of living? Increasing urbanization leads to rising affluence and the need for greater dollars for transactions in a more complex urban society!”

This may be the stupidest economics-related comment I’ve ever read from a trained economist, which is saying something considering the competition. It implies that he doesn’t know the difference between a rise in the quantity of the medium of exchange and a rise in the quantity of real wealth. It implies that he sees no difference between the private sector increasing the supply of labour-saving or life-sustaining or life-enhancing products and central banks creating new money out of nothing. Also, he apparently perceives the factual decline in the US dollar’s purchasing power as a goldbug delusion.

Harry Dent should not be taken seriously, but the view that deflation is coming should not be dismissed out of hand. Also, it is possible to make a legitimate gold-bearish argument, it’s just that Harry Dent hasn’t done it.

Under the current monetary system and the theories that dominate central banking, true deflation — such as occurred in the US during 1930-1932 — has a near-zero probability of happening. In the future there could (almost certainly will) be changes to the monetary system and/or the political environment that pave the way for true deflation, but that’s not something that has a realistic chance of happening over the next two years. In the meantime, there will probably be another deflation scare.

While it’s in progress a deflation scare will look and feel like 1930s-style deflation to most people. The difference is that you don’t get the economic ‘reset’ that would be caused by true deflation. Instead, policy-makers react to the scare by 1) aggressively injecting new money into the economy, 2) ensuring that the total volume of credit continues to grow, and 3) generally doing whatever it takes to prop-up prices. In doing so they add new imbalances to the existing imbalances.

Deflation scares are very bullish for gold. That’s why the deflation scare of 2001-2002 set in motion a large multi-year advance in the gold price and why the deflation scare of 2007-2009 set in motion a large multi-year advance in the gold price. If another deflation scare gets underway this year then so, in all likelihood, will another large multi-year advance in the gold price.

Looking out over the coming 1-2 years, the risk for gold isn’t that there will be true deflation, because that’s a virtual impossibility under the current monetary set-up. Nor is the realistic possibility of a deflation scare a risk for gold, since such a development would create a very gold-bullish fundamental backdrop. Rather, the risk for gold is a continuation of the monetary-inflation-fueled boom of the past few years.

In effect, the main risk for gold is an economic outcome that is almost the OPPOSITE of what Harry Dent is predicting.

*Harry Dent’s modus operandi is to come out with a new ‘big prediction’ almost every year. This creates a media buzz that facilitates the sale of books. If a big prediction doesn’t pan out, no problem — just make another one. Eventually, one will hit the mark. In the early-1990s he got lucky and correctly predicted the ensuing boom (it was blind luck because his reasoning was wrong). If he gets lucky again, he’ll have a track record to shout from the hilltops.

Assuming that useful price clues are what you want, it’s pointless to analyse the flow of gold into China and within China. I explained why HERE, HERE and HERE. I’ll write about the bogus ‘China gold demand’ theory again in the future as it’s one of the most persistent false beliefs within the bullish camp, but in this post I’m going to quickly deal with another China-related false belief that periodically shifts to the centre of the bullish stage: the idea that China’s government is preparing to back the Yuan with gold.

I was going to write in detail about why a gold-backed Yuan is a pipe dream, but then I discovered Geoffrey Pike’s article on the same topic and realised that doing so would be akin to reinventing the wheel. This is because the aforelinked article encapsulates the argument I would have attempted to make. You should click on the link and read the entire piece (it isn’t long), but here’s the conclusion:

“There is no way that the Chinese central planners are going to voluntarily give up an enormous amount of power by going to some form of a gold standard. It would drastically reduce their ability to spend money. It would reduce their power. It would limit their ability (or lack of) to centrally plan the economy.”

Given that there are good reasons to expect gold to resume its long-term bull market in the not-too-distant future, why do so many bullish gold analysts argue their cases using the equivalent of fairy stories?

During the week since I first wrote about BitGold (XAU.V) the stock price has been on a wild ride. It went from C$4.14 up to C$8.00, down to C$4.50, up to C$6.50, and ended the 25th May trading session at C$5.60. At C$5.60/share and with a new (post-acquisition) share count of around 50M, the company has a market cap of roughly C$280M (US$230M). The product appears to be excellent from the perspective of customers, but is the business really worth US$230M?

Let me ask the above question in a different way. With its current fee structure and likely user base it’s possible that BitGold will never be consistently profitable and cash-flow positive. If a business does not have a good chance of ever being consistently profitable or cash-flow positive, what’s it worth?

As a standalone enterprise it is worth very little, especially considering that the company in question could run into regulatory problems after it puts its debit card into operation (this is the point at which governments will start taking a keener interest). However, it could be worth a lot to another company if the money-losing business is complementary to the acquirer’s existing business. For example, companies such as Google and Facebook have paid huge sums (billions of dollars) for businesses that would likely never be consistently profitable as standalone enterprises. They’ve done so because of the value that these businesses would potentially add to the existing Google and Facebook operations.

In any case, I doubt that anyone who has bought BitGold shares at prices above C$4 has done a realistic calculation of the business’s value as either a standalone enterprise or as an add-on to a larger financial services company. Actually, very few of the buyers would have done any calculation of value whatsoever. Instead, they would have bought because they like the idea of BitGold, oblivious to the fact that a good business can be a bad investment at the wrong price, or because they think that someone else will be dumb enough to pay an even higher price in the future.

Moving on, I’m impressed by the company’s senior managers. They did a terrific job of setting up an electronic gold-trading/payment platform, because the system, although simple from a customer’s perspective, is complex. In addition, they have done a fine job to date of whipping up enthusiasm for the stock and they demonstrated financial acumen by using the over-valued shares to make a big acquisition.

The big acquisition I’m referring to is the purchase of GoldMoney.com (GM), a company founded by James Turk, for about C$50M in XAU shares. GM was originally designed to do what BitGold is now planning to do, although it has since turned into a precious-metals dealing and storage service (it provides a cost-effective way for people to buy, hold and sell gold and other PMs without the hassle of taking delivery).

The first press release announcing the acquisition of GM was issued prior to the start of North American trading last Friday and was very misleading. Almost no financial details of the GM business were provided and the information that was provided created a false impression. Canada’s stock-market regulators obviously picked up on this, as the company’s plan to have its shares re-open for trading last Friday morning (the stock had been halted pending the news) had to be abandoned while it put together a new press release containing more details of what it was buying. This second attempt also appears to have been deemed unacceptable by the regulators, however, so the stock remained halted and a third press release announcing the GM acquisition was put out on Monday morning. The third time was the charm and the stock resumed trading around mid-day on Monday 25th May.

The financial details provided in the final press release revealed that GM’s business was shrinking at a rapid pace, that GM had generated only $5M of cash flow in its best year (2011), and that it was cash-flow negative over the past two years.

It’s unlikely that GM’s 135,000 current users will be significantly more profitable as part of BitGold than they were as part of GM.

I’m yet to read a proper valuation analysis (one that uses realistic assumptions) that demonstrates why BitGold deserves a multi-hundred-million-dollar market cap. Actually, I’m yet to read any proper valuation analysis from the bulls. According to the bullish articles I’ve read, you should simply buy the stock because the product is a great idea and the company’s founder is very smart. It’s as if there is no limit to what you should pay for an investment as long as there is a good story behind it. The bulls on the stock also point out that some big-name investors have taken significant BitGold positions. This is true, but the big-name investors generally paid C$0.90/share or less for their stakes. I could be wrong, but I doubt that they are interested in buying near the current price.

I don’t want it to seem as if I’m on some sort of crusade against BitGold. I very much want the business to succeed, because I like the product and want it to remain available. My only issue is with the stock’s valuation.

Even if the product makes great strides in popularity, with its current fee structure the underlying company will always be a low-margin business and therefore deserving of a low valuation. This, of course, doesn’t guarantee that the stock’s valuation won’t go a lot higher than its current elevated level, given the public’s proven ability to ignore valuation for long periods. There is also a chance that if BitGold can grow its customer base into the millions then it will be worth a lot to another electronic payment company such as PayPal or Mastercard, even if the BitGold business is a consistent money-loser. That’s one reason I definitely wouldn’t want to be short the stock and why, in terms of practical stock-market speculation (my primary source of income), I have no desire to get involved. Instead, I’ll continue to watch from the sidelines with detached amusement.

Summing up, my concern is 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 will collide with the “it will always be a low-margin business and therefore deserves a low valuation” brick wall of reality.