One of my readers sent me the following two-paragraph excerpt — written by someone called “Bill H” about a debate between Chris Powell and Doug Casey at a recent conference — from a commentary at lemetropolecafe.com, a web site dedicated to the idea that downward price manipulation dominates the gold market. He asked me to comment on the second paragraph, but I’ll do better than that — I’ll comment on both paragraphs. I’ll explain why the first paragraph contains a misunderstanding about economics and why the second paragraph reveals extreme ignorance of the gold market. First, here’s the excerpt:

“Powell also pointed to Larry Summer’s Gibson paradox study where low gold prices also aid in low interest rates and allow for more debt and currency issuance than would otherwise be the case. He also pointed to documents from the CME that shed light on the fact the central banks are “customers” and actually receive volume discounts for trading. Chris then mentioned that just because gold has gone higher, this is not evidence of no suppression as gold would or could be much higher in price if it were not for suppression. In answer to Casey’s statement “we would never suppress the prices of gold and silver because this would aid the Chinese and Russians”, insider Jim Rickards claims a “deal” has been struck with the Chinese.

I have no proof of this one way or the other but it does make perfect sense to me. I could write an entire piece on this subject but for now a paragraph will have to suffice. If China (and India) are buying more than the entire year’s global production of gold …yet the price has been dropping during this operation …the metal HAS to be coming from somewhere. The ONLY “somewhere” this can be is from where it is (has) being stored, central bank vaults. The only possible way for prices to not rise when physical demand grossly exceeds supply is through the use of paper derivatives. It is really just this simple. In my opinion what Jim Rickards has said must have some truth behind it, some sort of deal has to have been struck which allows China/India (and Russia) to purchase increasing amounts of gold at decreasing prices. As I have said all along, once China cannot receive gold in exchange for dollars …then of what use are their dollar holdings? Do you see? The game will be up and there will be no incentive to China whatsoever to hold any dollars which will …end the game.”

The misunderstanding about economics has three parts.

First, “Gibson’s Paradox” only applies in the context of a Gold Standard. It has no relevance to the current monetary system.

Second, there is actually no paradox.

As an aside, Keynesian economists sometimes arrive at what they consider to be paradoxes, the “Paradox of Thrift” being the classic case. However, this is only because they are being guided by hopelessly flawed economic theories. For example, Keynesians get the economic growth process completely backward. They think it begins with consumer spending, when in reality it ENDS with consumer spending and begins with saving. That’s why they believe that an economy-wide increase in saving (meaning: a reduction in consumer spending in the present) is bad for the economy and must be discouraged. In the case of “Gibson’s Paradox”, which revolves around the link between interest rates and the general price level under a Gold Standard, there will only be a paradox for the economist who doesn’t understand the relationship between interest rates and time preference (the desire to spend money in the present relative to the desire to delay spending (to save, that is)).

Third, if gold were being manipulated today in accordance with the relationship between gold and interest rates that existed during the Gold Standard, then an effort to create lower interest rates would involve an effort to manipulate the price of gold UPWARD relative to the prices of most other commodities (under the Gold Standard, a decline in interest rates tended to be associated with a rise in the purchasing power of gold). Strangely, this is what happened over the past 7 years, in that the gold/commodity (gold/CCI) ratio rose as interest rates fell and reached a multi-generational high in 2012 at around the same time as interest rates on long-dated US Treasury securities reached a multi-generational low.

Now, I’m not saying that gold was manipulated upward relative to other commodities as part of an attempt to suppress interest rates. These days central banks make full use of their power to manipulate interest rates directly, thus obliterating any reliable link between the price of credit and the general desire to spend/save. Central banks have even gone a long way towards obliterating any link between the price of credit and the risk of default. In a nutshell, interest rates have been distorted to the point where they no longer provide valid signals. What I’m saying is that you need to have a sub-par understanding of economics to believe that gold has been manipulated downward as part of a scheme to create lower interest rates.

I could write a lot more about the relationships between economy-wide time preference, interest rates, the general price level and gold, but I don’t want to get bogged down and this post is already longer than originally intended. Instead, let’s move on to the second of the excerpted paragraphs.

I was particularly impressed by the following sentences:

“If China (and India) are buying more than the entire year’s global production of gold …yet the price has been dropping during this operation …the metal HAS to be coming from somewhere. The ONLY “somewhere” this can be is from where it is (has) being stored, central bank vaults. The only possible way for prices to not rise when physical demand grossly exceeds supply is through the use of paper derivatives. It is really just this simple.”

These sentences reflect a very basic misunderstanding about the gold market that I end up addressing several times every year in TSI commentaries. The fact is that the supply of gold is NOT the annual amount of gold produced by the mining industry. Rather, the mining industry adds only about 1.5% to the total supply of gold every year. This is why changes in mine production have almost no effect on gold’s price trend and why it is illogical to compare the gold demand of some countries or regions with annual mine production.

The total supply of gold is around 170,000 tonnes, and over the next 12 months the mining industry will add about 2,500 tonnes to this total supply. Furthermore, the mining industry is no different to any other seller (an ounce of gold mined over the past year is the same as an ounce of gold that has been sitting in storage for the past 200 years), except that it is price-insensitive. The mining industry will sell its 2,500 tonnes regardless of price, whereas the actions of the holders of the existing 170,000 tonnes of aboveground gold will be influenced by changes in the gold price and changes in the perceived attractivess of gold as an investment or store of value.

Some existing holders (the weak hands) are likely sellers in response to price weakness, whereas other holders are likely sellers in response to price strength. Some existing holders will change their plans based on their assessments of current and likely future conditions, whereas others will be determined to hold forever. At the same time there are a huge number of potential buyers, some of whom will be planning to buy in response to lower prices, some of whom will be likely to buy in response to signs of an upward trend reversal, and many of whom will change their plans based on changes in the financial world.

The main point to be appreciated here is that it’s the urgency to sell on the parts of existing holders of the total gold stock relative to the urgency to buy on the parts of prospective new owners that determines the change in price. As noted above, the gold mining industry is just one small piece of a very big puzzle.

Finally, I’m not going to attempt to debunk the unsubstantiated claim that the US government has made a deal with the Chinese government whereby the gold price will be held down to facilitate the latter’s gold accumulation. This is just a nonsensical story.

This blog post is a slightly modified excerpt from a recent TSI commentary.

“If you believe in the thesis that world GDP will continue to expand and that population growth will continue, then you should own natural resources. New people who are born will want to eat, drive, and build houses. This trend offers long-term support for natural resources.”

The above is a comment by Rick Rule in an article titled “Are the Worst of Times Yet to Come?“. I consider Rick Rule to be a brilliant investor in natural-resource companies and agree with his investment strategy. I also agree with everything in the afore-linked article EXCEPT the above comment. If it is true that the prices of natural resources are supported by economic and population growth, then why is it that world population and world GDP have grown relentlessly over the past 200 years and yet over that entire period the real prices of most commodities have been in downward trends?

The fact is that economic growth causes prices, including the prices of most natural resources, to become LOWER, not higher. Real growth involves producing more with less. That’s why the fastest-growing industries generally have downward-trending product prices. However, the downward trend in prices that would otherwise occur due to real growth can be counteracted by monetary inflation and political intervention, and these days that’s exactly what happens most of the time. These days, monetary inflation causes prices (prices in general, not all prices) to have an upward bias even during periods of economic progress — periods when prices, on average, should be trending downward. This is because in addition to reducing the purchasing power of money, an effect of monetary inflation is to make the economy less efficient by distorting relative price signals. Political intervention also puts upward pressure on prices by placing obstacles in the way of more efficient production.

Consequently, genuine economic growth is most definitely not an ingredient for large rises in natural-resource prices. Instead, two of the three main ingredients are monetary inflation and an increase in politically-motivated/directed spending.

The third main ingredient is valuation. The relative valuations of different assets and commodities will have a big influence on which prices are affected the most by the current cycle’s monetary inflation. In particular, for commodities to be major beneficiaries of monetary inflation, commodity prices should be low relative to the prices of equities and bonds. According to the following weekly chart, commodity prices (as represented by the CCI) are currently near a 10-year low relative to the S&P500 Index, which is certainly low enough to enable a multi-quarter period of relative strength.

From the Stock market section of the Weekly Market Update posted on 19th October, under the heading “What to do”:

“We have no idea what anyone else should do, apart from maintain a substantial cash reserve. Having exited all stock-market-related put options last week, the short-term plan for our own account is to begin averaging into January-2016 SSO (ProShares Ultra S&P500) put options following some additional rebounding activity over the next few weeks. We might also average into the unleveraged, actively-managed bear funds previously mentioned at TSI (BEARX and HDGE).

This plan assumes that a multi-week low was put in place last week. If this assumption is wrong and it turns out that the initial decline from the September peak is not yet over, then we will take no action. We will not enter bearish speculations when the market is in the midst of a sharp decline.“

I’m posting this brief comment to advise that if the US stock market opens strongly today (Tuesday) then I will probably take an initial position in the aforementioned SSO put options or some other puts. I want some coverage in case the rebound fails sooner than anticipated.

I also want to make readers aware that Almaden Minerals (AAU) and True Gold Mining (TGM.V) issued bullish press releases earlier today. The news will be discussed, as usual, in the next Weekly Update.

Despite the fact that the NASDAQ Composite and NYSE Composite Indices tested Wednesday’s intra-day lows on Thursday 16th October, the number of individual NYSE and NASDAQ stocks making new 12-month lows collapsed on Thursday. The relevant charts are shown below. Across the NASDAQ and NYSE markets, the number of new lows fell from around 660 on Wednesday to around 200 on Thursday. This has bullish implications with regard to the next few weeks.