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

Here is chart that compares the long-term inflation-adjusted (IA) performances of several markets. This chart makes some interesting points.

One of the most interesting points is that market volatility increased dramatically in the early-1970s when the current monetary system was ushered in. This shows that the generally higher levels of monetary inflation and the larger variations in the rate of monetary inflation that occurred after the official link to gold was abandoned didn’t only affect nominal prices. Real prices were affected in a big way and boom-bust oscillations were hugely amplified. As an aside, economists of the Keynesian School are oblivious to the swings in relative ‘real’ prices caused by monetary inflation and the depressing effects that these policy-induced price swings have on economic progress.

A second point is that commodities in general (the green line on the chart) have experienced much smaller performance oscillations than the two monetary commodities (gold and silver). This is consistent with my view that there aren’t really any long-term broad-based commodity bull markets, just gold bull markets in which most commodities end up participating.

A third point is that apart from the CRB Index, the markets and indices included in the chart have taken turns in leading the real performance comparison. The chart shows that gold is the current leader, closely followed by the Dow Industrials Index (since January-1959, the percentage gain in gold’s real price is slightly greater than the percentage gain in the Dow’s real price). However, if dividends were included, that is, if total returns were considered, the Dow would currently be in the lead. This will change.

    Chart Notes:

1) I use a method of adjusting for the effects of US$ inflation that was first described in a 2010 article. This method isn’t reliable over periods of two years or less, but it should come close to reflecting reality over the long term.

2) To make it easier to compare relative performance, the January-1959 starting value of each of the markets included in the above chart was set to 100. In other words, the chart shows performance assuming that each market started at 100.

3) The monthly performance of the scaled IA silver price peaked at more than 2600 in early-1980, but for the sake of clarity the chart’s maximum Y-axis value was set to 1500. In other words, the chart doesn’t show the full extent of the early-1980 upward spike in the IA silver price.

Every transaction in a market involves an increase in demand for the traded item on the part of the buyer and an exactly offsetting decrease in the demand for the traded item on the part of the seller, which means that neither a purchase nor a sale implies a market-wide change in demand or price. This is obvious, so why does so much gold-market analysis focus on the quantities of gold shifting from one geographical area to another or from one part of the market to another?

I don’t know the answer to the above question, but I do know that focusing on the changes in gold location is pointless if your goal is to find clues regarding gold’s prospects. For example, while there could be a reason for wanting to know the amount of gold being transferred to China (I can’t think of a reason, but maybe there is one), the information will tell you nothing about the past or the likely future performance of the gold price. For another example, the amount of gold shifting into or out of ETF inventories could be of interest, but the shift in location from an ETF inventory to somewhere else or from somewhere else to an ETF inventory is not a driver of the gold price (as I explained in a previous blog post, changes in ETF inventory are effects, not causes, of the price trend).

Over recent years many gold bulls have cited the net-buying of gold by the geographical region known as China as a reason to expect higher prices. Prior to that it was often the net buying of gold by India that was cited as a reason to be bullish. The point that is being missed in such arguments is that regardless of whether gold’s price trend is bullish or bearish, some parts of the world will always be net buyers and other parts of the world will always be net sellers of gold, with the two exactly offsetting each other. At some future time it is possible that China will become a net seller and the US will become a net buyer. If so, will the same pundits that have wrongly cited the buying of China as a reason to be bullish then start wrongly citing the buying of the US as a reason to be bullish? Unfortunately, they probably will.

What determines gold’s price trend isn’t the amount of gold bought, since the amount bought will always equal the amount sold. Instead, the price trend is determined by the general urgency to sell relative to the general urgency to buy (with the relative urgency to buy/sell being strongly influenced by confidence in the two senior central banks). To put it another way, if the average buyer is more motivated than the average seller, the price will rise, and if the average seller is more motivated than the average buyer, the price will fall. So, how do we know whether the buyers or the sellers are the more motivated group?

The only reliable indication is the price itself. If the price is rising we know, with 100% certainty, that buyers are generally more motivated than sellers. In other words, we know that demand is trying to increase relative to supply. And if the price is falling we know, with 100% certainty, that sellers are generally more motivated than buyers. In other words, we know that demand is trying to decrease relative to supply.

That’s why statements along the lines of “demand is rising even though the price is falling” are just plain silly.

One of the most interesting aspects of the recent steep downward trend in the copper price is that it occurred in parallel with a rising trend in the gold price. This doesn’t guarantee anything, but it is consistent with what should be happening if the commodity markets have begun the transition from cyclical bear to cyclical bull.

By way of explanation, long-term broad-based rising trends in commodity prices are always driven by bad monetary policy. A consequence is that gold, due to its nature, will generally turn higher in advance of most other commodities. In effect, there are no long-term broad-based commodity bull markets, just gold bull markets that most commodities end up participating in.

A good example occurred during 2001-2002. As illustrated by the chart displayed directly below, in 2001 the copper price continued to trend downward for 7-8 months and fell by more than 20% after gold’s price trend reversed upward. 

As illustrated by the next chart, there was a ‘head fake’ during the first quarter of last year, with gold rising while the copper price tanked. A similar situation has developed since early-November.

If gold bottomed on a long-term basis last November, then copper should do the same within the next few months.

Some government bonds are now being quoted with negative yields. Taking an extreme example, Swiss government bonds are now being quoted with negative yields for all maturities up to 10 years. This prompts the question: Who, in their right mind, would pay a government for the ‘privilege’ of lending the government money?

The zero or negative bond yields are almost certainly related in part to the desire by large cash-holders to ensure a return of cash, even if doing so guarantees a small nominal loss. By way of further explanation, if you have $100K of cash to park somewhere you can put it in an insured bank deposit and be guaranteed of getting your money back, but what do you do if you have $1B of cash? If you put this money into a bank account then only a trivial portion will be covered by the government’s deposit insurance, meaning that the failure of the bank could result in a substantial portion of your money being wiped out. To avoid the risk of a large loss due to bank failure it might seem reasonable for you to lend the money to the government at a yield that is certain to result in a small loss. In this case, the small loss stemming from the negative yield on your bond investment is a form of insurance that guarantees the return of almost all of your money.

In other words, at a time when “inflation” risk is perceived to be low and there are concerns about the safety of commercial banks, it could make sense for a large holder of cash to lend the money to the government at a small negative yield.

That being said, it’s important to remember that we aren’t really dealing with 0% or negative bond yields, we are dealing with 0% or negative yields to maturity. The bond yields themselves are still positive.

To further explain, consider the simple hypothetical case of a 1-year bond with par value of $100 that pays interest of $2 at the end of the 1-year duration. If the bond is trading at its par value then both the yield and the yield to maturity (YTM) will be 2%, but both yields will be something other than 2% when the bond’s price deviates from $100. For example, if the bond’s price rises to $103 then the yield falls to 1.94% ($2/$103) and the YTM falls to negative 0.97%. The YTM in this example takes into account the fact that if the bond is held until maturity then the buyer of the bond at $103 will receive a $2 interest payment plus a $100 principle payment, or a total return of $102 versus an outlay of $103. The $1 loss on the $103 investment equates to a return of negative 0.97%.

An implication is that someone who doesn’t plan to hold until maturity can still make a profit on a bond with a negative YTM. For example, someone who buys a Swiss government bond with a YTM of negative 0.1% today will have the opportunity of selling at a profit if the YTM subsequently falls to negative 0.2%. The current ridiculous valuations of some government bonds could therefore be partly explained by the belief that valuations will become even more ridiculous in the future, thus enabling today’s buyers to exit at a profit.

That is, in addition to the willingness to accept a small loss for a guarantee that almost all of the money will be returned, the “greater fool theory” could be at work in the government bond market. In this regard, a government bond having a negative YTM is not that different from an internet stock with no revenue being assigned a multi-hundred-million-dollar valuation based on “eyeballs”. It’s just another in a long line of examples of the madness of crowds, a madness that is often rooted in central bank policy.