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.

In a shot out of the blue, on Thursday 15th January the Swiss National Bank (SNB) suddenly removed the Swiss-Franc/Euro cap that was put in place in August of 2011. Due to the cap that was imposed by the SNB way back then, the SF has effectively been pegged to the euro over the past three-and-a-bit years. Since the SF was a chronically stronger currency than the euro, maintaining this peg forced the SNB to massively expand its balance sheet by monetising huge quantities of euro-denominated bonds.

It seems that the SNB belatedly came to see that continuing to peg the SF to the euro created the risk that the SF would become excessively weak and unstable. The sensible, but surprising, decision was therefore made to eliminate the peg. A result was a gigantic single-day surge in the SF relative to all other currencies, not just the euro. For example, the following chart shows that the SF gained almost 20% relative to the US$ on Thursday. As far as we know, this is the biggest single-day move by a major currency in at least 50 years.

It should be noted, however, that the SNB’s shift to a more prudent monetary stance was only half-hearted, because at the same time as it announced the removal of the SF/euro cap it also announced that official 3-month interest rates would be set between NEGATIVE 0.25% and NEGATIVE 1.25%. In effect, the SNB is saying that it will pay speculators to short the SF.

In early October of last year I published an article (an excerpt from a TSI commentary) dealing with why the US$ was rallying. The point I tried to get across in this article was that rather than the main cause of the euro’s weakness — and the Dollar Index’s associated strength — being the fear that the ECB was going to stimulate (meaning: inflate the money supply) more aggressively, the main cause was the fear that the ECB would be unable to stimulate aggressively enough to sustain the bull markets in European stocks and bonds.

The argument I made at that time was based on the strong positive correlation over many years between the euro and the performance of European equities relative to US equities (as indicated by the VGK/SPX ratio). Specifically, the fact that relative strength in European equities invariably went with a rising euro and relative weakness in European equities invariably went with a falling euro implied that bullish influences on European equities would also tend to be bullish for the euro. At a time when inflation fears are low, nothing is more bullish for the broad stock market than monetary inflation.

Consequently, it was clear to me then, and it is just as clear to me now, that if the market starts to believe that the ECB will have greater ‘success’ in its efforts to pump more money, then the euro will rally on the back of relative strength in European equities.

Here are charts (one long-term and one short-term) that illustrate the relationship between currency performance and relative equity performance that I’m talking about.

Here is a slightly-modified excerpt from a commentary posted at TSI last week:

Following the lead of Doug Kass I am now going to present a list of financial-market surprises for the year ahead. These are events/developments that are expected by very few market participants and commentators, but in my view have either a greater than 50% chance of happening (in the cases of surprises 1 to 6) or at least a high-enough probability of happening to be worthy of serious consideration (in the cases of surprises 7 to 9). Here’s the list:

1) The Fed continues to make noises about ‘normalising’ monetary policy, but ends up doing almost nothing. At most, there is a single 0.25% rate hike. One reason is the fear that economic weakness elsewhere in the world, primarily the euro-zone, will weigh on the US economy. Another reason is the absence of an obvious “price inflation” problem. A third reason is the Fed’s unwavering commitment to the absurd Keynesian idea that an economy can be strengthened by punishing savers.

2) US Treasury yields defy the majority view by ending the year flat-to-lower. More specifically, the 30-year T-Bond yield is roughly unchanged over the course of the year, but yields decline in the middle and at the short end of the curve. Of all the Treasury securities, the 5-year T-Note experiences the largest decline in yield as traders belatedly realise that the Fed will not be taking any significant steps towards ‘policy normalisation’ during 2015 or 2016.

3) Gold defies the numerous calls for a decline to US$1000 or lower. It does no worse than test its 2014 low during the first half of the year and commences a major upward trend by the middle of the year. As is always the case, gold’s bullish trend is driven by declining confidence in central banking and rising concern about ‘tail risk’. A related surprise is that the gold-mining indices outperform gold bullion.

4) Despite superficially lousy fundamentals, concerns about future supply reductions/disruptions cause oil to commence a cyclical bull market during the second half of the year.

5) The recovery in the oil price comes too late to prevent widespread debt default and bankruptcy within the US oil-and-gas industry. Due to the many knock-on effects of large-scale retrenchment within this industry, including slowdowns in all the businesses that indirectly benefited from the flood of money channeled into the drilling of shale deposits, it becomes clear that the collapse in the oil price was a net-negative for the US economy.

6) The Yen ends 2015 more than 10% higher than it ended 2014 as the Yen supply continues to grow at a comparatively slow annualised rate of less than 5% and carry-traders exit their positions in reaction to increasing risk aversion.

7) The S&P500 never closes above its December-2014 peak and generally works its way lower throughout the year.

8) The Russian currency (the Ruble) and stock market (RSX) bottom-out during the first half of the year and end 2015 with net gains.

9) The copper price trades below US$2.30/pound during the first half of the year within the context of a deflation scare and downwardly-revised forecasts for global economic growth.

In his memoirs, US President Herbert Hoover says that he received the following advice from Secretary of the Treasury Andrew Mellon after the stock market crash of 1929:

“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.” According to Hoover, Mellon “insisted that, when the people get an inflation brainstorm, the only way to get it out of their blood is to let it collapse” and that “even a panic was not altogether a bad thing.”

In other words, if Hoover’s recollection was correct (it probably was), Mellon’s advice was for the government to stay out of the way and let the markets clear.

Paul Krugman and many others have blamed the course of action recommended by Mellon for the severity of the Great Depression of the 1930s. The problem with this line of argument is that Hoover strenuously disagreed with Mellon’s advice and chose not only to ignore it, but to do the exact opposite!

Hoover was an engineer by education who believed that the economy could be managed as if it were a giant engineering project. He was an aggressively interventionist president who thought that the economic pain that the stock market crash suggested was coming could be lessened by, among other things, preventing prices from falling and replacing private-sector demand with public-sector demand. He was a consistent critic of free (unregulated) markets and a relentless advocate for a greatly expanded role for government. He was actually a pre-Keynes Keynesian (Keynes was a prominent figure in economics at the time, but he hadn’t yet written the book that would become the bible for government economic meddling).

As an aside, during the 1932 presidential election campaign FD Roosevelt lambasted Hoover for being fiscally imprudent. In fact, FDR went as far as describing the Hoover Administration as “the most reckless and extravagant…of any peacetime government anywhere, any time.” However, after taking over the Presidency FDR quickly forgot almost everything he had said during the election campaign and greatly extended the interventionist approach initiated by his predecessor.

I strongly believe that Mellon’s advice was sound, but the point I want to make right now is that this advice cannot logically be blamed for worsening the economic downturn of the 1930s, regardless of whether or not it was sound. This is because the advice was not followed.

Here is some fascinating video footage showing Hong Kong in 1938.

The narration sounds like it was produced by the British Ministry of Propaganda and some of the narrator’s comments are patronising to the point of being funny. This mouthful is my favourite:

“Under tolerant and wise British rule, with willing oriental assistance, has grown a modern Western city in an Eastern setting, where more than a million contented Chinese dwell in harmony, merging their ancient civilisation, culture and manners with those of the 20 thousand Europeans who guide or minister to them.”

Video source: https://www.youtube.com/watch?v=hIHTrmz4hTI

This post is a reiteration of the points I made in my 16th December article and includes updated charts. The main point is that there are times, like now, when less ‘accommodative’ monetary policy is absolutely not bearish for gold.

The Fed announced the beginning of its QE “tapering” on 18th December 2013. The following charts show that within a few days of this announcement gold made a major bottom in non-US$ terms (the gold/UDN ratio is a proxy for gold’s performance in terms of a basket of important currencies excluding the US$) and an intermediate-term bottom in US$ terms.

The Fed then methodically “tapered” its QE program during 2014 and announced the completion of the program on 29th October. The following charts also show that within a few days of this announcement gold bottomed in both non-US$ terms and US$ terms.

Over the past two days gold broke out to the upside in non-US$ terms and appears to have completed a long-term base.

As I explained in the above-linked article, the critical point to understand is that gold’s perceived value moves in the opposite direction to confidence in central banking and the economy. During periods when a general belief takes hold that the central bank’s money-pumping is improving the economy’s prospects, the money-pumping turns out to be an intermediate-term bearish influence on the gold market. However, the money-pumping distorts the economy in a way that eventually leads to substantial economic weakness.

A tightening of monetary conditions will begin to reveal the distortions (mal-investments) caused by the preceding ‘monetary accommodation’, which is why the demand for gold will sometimes increase as the Fed becomes more restrictive. In such a situation gold isn’t gaining ground because the Fed is tightening, it is gaining ground because tighter monetary conditions are shining a light on the economic damage caused by the earlier money-pumping.

In simpler terms, gold gets hurt by the boom and helped by the bust, so anything that perpetuates the boom is bearish for gold and anything that helps bring on the bust that inevitably follows an inflation-fueled boom is bullish for gold.

My 3rd November blog post explained why leveraged ETFs should only ever be used for short-term trades. To set the scene, here is an excerpt from this earlier post:

“The crux of the matter is that leveraged ETFs are designed to move by 2 or 3 times the DAILY percentage changes of the target indexes. They are NOT designed to move by 2 or 3 times the percentage change of the target indexes over periods of longer than one day. Due to the effects of compounding, their percentage changes over periods of much longer than one day will usually be less — and sometimes substantially less — than 2-times (in the case of a 2X ETF) or 3-times (in the case of a 3X ETF) the percentage changes in the target indexes.”

In the earlier post I presented tables to show that the greater the volatility of an index and the greater the leverage provided by an ETF linked to the index, the worse the likely performance of the leveraged ETF over extended periods. The worse, that is, relative to the performance superficially implied by the daily percentage change relationship between the index and the leveraged ETF. I concluded that leveraged ETFs are only suitable for short-term trades and that a trade should be very short-term if it involves a 3X ETF and/or a volatile market.

To illustrate how badly a leveraged ETF can perform relative to the performance superficially implied by the daily percentage change relationship between the leveraged ETF and the market to which it is linked, here is a chart comparing the performances of GDXJ (the Junior Gold Miners ETF) and JDST (the Junior Gold Miners 3X Bear ETF) since the end of 2013. JDST is designed to have a daily percentage change that is roughly three times the INVERSE of GDXJ’s daily percentage change, so it is an ETF that someone would buy if they were bearish on GDXJ. For example, on a day when GDXJ lost 5%, JDST would gain about 15%, and on a day when GDXJ gained 5%, JDST would lose about 15%.

Given that GDXJ is presently about 15% lower than it was at the end of 2013, people who are unfamiliar with how leveraged ETFs work would likely jump to the conclusion that a JDST position purchased at the end of 2013 and held through to the present would show a healthy profit. However, this conclusion could not be further from the truth, because JDST has lost 81% of its value over the period in question.

The dismal performance of JDST is a trap for the novice trader, but it is not a design flaw. As outlined in my 3rd November post, it is a mathematical function of how the leverage works and simply means that this type of ETF should only ever be used in trades with timeframes of no more than a few weeks.

The following charts are referenced in a market update to be emailed to TSI subscribers prior to Monday 5th January.

Chart 1: Gold in US$ terms

Chart 2: Gold in euro terms

Chart 3: Gold relative to the Industrial Metals Index

Chart 4: XAU

Chart 5: Gold stocks relative to gold bullion (HUI/gold)

Chart 6: Junior gold miners (GDXJ) and juniors relative to seniors (GDXJ/GDX)

Chart 7: Natural Gas

Charts 8, 9 & 10: Asanko Gold (AKG), Endeavour Mining (EDV.TO) and Timmins Gold (TGD)

1) Rescue major banks by transferring to them, through various channels, a few hundred billion dollars of taxpayers’ money.

2) Call this money transfer the Troubled Asset Relief Program (TARP), because calling it the Bailout At Taxpayer Expense (BATE) program wouldn’t create the right impression.

3) Justify the money transfer by claiming that it is necessary to prevent a total financial collapse and massive losses to bank depositors, even though, in reality, bank deposits are not at risk and the financial system would actually be strengthened by allowing excessively indebted/leveraged financial institutions to go bust.

4) Implement monetary policies that, over the space of several years, effectively transfer trillions of dollars from savers and middle-class wage earners to the balance sheets of banks and other financial speculators.

5) When the banks, flush with the huge profits stemming from the carry-trade opportunities provided by many years of limitless access to near-zero-cost short-term credit, pay back the TARP money with a smidgen of interest, declare the whole exercise to be a resounding success for taxpayers and the economy.

The following charts are related to a market update that was emailed to TSI subscribers.

Central banks will continue to create money in response to economic weakness until blatant “price inflation” stops them. This is why the US economic situation is all but guaranteed to deteriorate.

To explain, I point out that if the Fed had done nothing in response to the bust of 2000-2002 then there would have been a severe recession, but the economy would probably have made a full recovery by 2004 and there would have been no mortgage-credit/housing-investment bubble and therefore no 2007-2008 crisis. However, the Fed, in its wisdom and at the behest of intelligent idiots such as Paul Krugman and Paul McCulley, kept interest rates at artificially low levels for years and aggressively ramped up the money supply with the aim of speeding the recovery process. In doing so it fueled a further rapid expansion of debt and a new bubble.

If the Fed had done nothing when this new bubble inevitably burst in 2007-2008 then there would have been a more severe recession, but the US economy would probably have made a full recovery by 2010 or 2011. It would certainly not now be teetering on the verge of another devastating bust.

During 2001-2004 and again since 2008, the Fed felt free to encourage rapid increases in the supplies of money and credit because there were no obvious negative “price inflation” consequences to be seen by those who fixate on price indices such as the CPI. Therefore, the lack of an obvious “price inflation” problem in the US should be viewed as a threat, not a benefit. From the perspective of the people pulling the monetary levers, it provides carte blanche for more money-conjuring in response to economic weakness.

You see, from the collective perspective of the ‘master manipulators’ at the monetary politburo, creating money out of nothing is never a problem until it causes the general price level — which, by the way, can’t be measured, but that doesn’t stop them from pretending to measure it and coming up with figures upon which policies are based — to rise faster than some arbitrary number. They appear to have no inkling that the falsifying of interest rates and relative price signals distorts investment decisions and the structure of production in a way that leads to an economic bust that wipes out all the superficial gains made in response to the so-called monetary stimulus.

If money-pumping continues to be the knee-jerk reaction to every new bout of economic weakness, then a “price inflation” problem will eventually arise. The longer it takes to arise, the greater the amount of damage that will be done in the meantime.

Men of good will should therefore be hoping for an outbreak of “price inflation”, it seemingly being the only way to end the destructive policy-making.

A couple of weeks ago I posted some information about the “Great Depression of 1873-1896″ to make the point that there was no depression, great or otherwise, during this period, but that the period did contain some financial crises/panics. Paul Krugman and others have blamed these financial crises on the Gold Standard, but, as explained in a well-researched article by Brian Domitrovic, the financial crises of the 1800s had similar causes to the financial crises of the 1900s and 2000s: monetary inflation and government meddling. Here are the last few paragraphs in the aforelinked article, dealing with the financial crisis and economic recession of the early-to-mid 1890s:

“It is perfectly clear what caused both the huge run-up in output numbers from 1890-92, as well as the tremendous stress on the banking and credit system that led to the drying up of investment and the shuttering of factories in 1893 and beyond. The United States, in 1890, decided to traduce the gold standard.

1890 was the year in which Congress made two of its most intrusive forays into monetary and fiscal policy in the years before the creation of the Fed and the income tax in 1913. It authorized the creation of fiat money to the tune of nearly five million dollars a month, and it passed a 50% increase in tax rates in the principal form of federal taxation, the tariff.

The monetary measure came care of the Sherman Silver Purchase Act, whereby the United States was mandated to buy, with new paper currency, an additional 4.5 million ounces in silver per month. The catch: the currency that bought the silver had to be redeemable to the Treasury in gold too.

Silver-mining interests in Nevada and elsewhere had conned (and surely bribed) Congress into this endeavor. Knowing that their extensive silver was worth little, what better way to cash in on it than get a piece of paper that says the silver can be exchanged for gold, government-guaranteed?

The cascade of new money caused an asset bubble, the tariff made sure the bubble was especially deformed, and the most extended recession of the pre-1913 period hit. The United States, needless to say, ran out of gold to back all the extra currency. J.P. Morgan had to float a gold loan to bail out his pathetic government. With the private banking system devoting its resources to propping up the United States, the market got starved of cash, and the terrible recession came.

In our own era, the Fed prints excess dollars without concern that they be redeemable in gold. Which means that our capital misallocation is extensive and long-term, our recessions are long and deep, our growth trend is shallow, and our complacency about how right we are in contrast to the benighted past is callow and pitiable.”

After gold and the gold-mining indices crashed during the final few days of October and the first few days of November, the most likely pattern over the weeks ahead was a rebound and then a successful test of the crash low. Gold bullion successfully tested its crash low on 1st December, but the gold-mining indices didn’t fall far enough at that time to complete a test. The reason is that by the time the North American stock markets opened for trading on 1st December, the gold price had already bounced off its early-November low and was rocketing upward.

The 1st December price action indicated that the gold-mining sector might be able to avoid a test of its crash low, but it wasn’t to be. The HUI and the XAU have just closed lower for five days in a row and are now testing their early-November lows.

I expect the next up-day for the HUI, whether it be today (Wednesday the 17th) or tomorrow or the day after tomorrow, to mark the completion of a successful test of the early-November low and the start of a larger/longer rally than the initial post-crash rebound.

Based on Cyclically Adjusted PE (CAPE), Russia’s stock market is the second cheapest stock market in the world. Its current CAPE is around 5, compared to 27.9 for the US. By this measure only the Greek stock market is cheaper, but the Greek stock market has no dividend yield to speak of. Taking into account both CAPE and dividend yield, the Russian market is clearly the world’s cheapest (refer to http://www.starcapital.de/research/stockmarketvaluation for valuation data on many stock markets around the world). This means that it will probably generate outsized returns over the next few years. However, the following chart suggests that it won’t start providing relatively good returns until commodity prices begin trending upwards, regardless of how cheap it gets.

The chart shows that the RSX/EEM ratio (Russian equities relative to Emerging Market equities) trends with the Continuous Commodity Index (CCI). Russia is in the news a lot these days, due to geopolitical issues, economic sanctions and other economic problems, and, at the time of writing this post, a desperate effort to stop the devaluation of the Ruble by hiking the official interest rate from 10.5% to 17%, but it’s the trend in commodity prices that really matters.

This post is a modified excerpt from a commentary posted at TSI a few weeks ago.

At its recent low the HUI was trading at the same price at which it traded way back in 2003-2004, when the gold price was $350-$400/oz. On the surface, this suggests that at their recent lows the senior gold-mining stocks that dominate the HUI were absurdly under-valued relative to gold, given that gold was trading at around $1150/oz at the time. Just how extreme was the under-valuation?

According to the article posted HERE, the HUI’s under-valuation was so extreme it was completely irrational. For example, the article contains the following statements:

“While gold stocks indeed should’ve been sold with gold weaker, the magnitude of selling they suffered was far beyond anything justifiable fundamentally. This ultimately culminated in the latest gold-stock capitulation where the HUI plunged to 11.3-year lows! Think about that a second. Gold stocks were just trading at prices not seen since July 2003. Pretty much the entire secular gold-stock bull had been fully erased.”

And: “… [the] entire not-widely-followed gold-stock bull was based on the massive fundamental boost to gold-mining profits that gold’s own secular bull created. So if the recent gold-stock price levels were righteous, gold too should have been pounded back down towards its mid-2003 levels. Where was gold trading back then? Merely right around $350!”

And: “Do gold stocks deserve to trade today as if gold was at just $350? Heck no! Last week when gold stocks’ latest capitulation low was carved, the gold price was up near $1150. That was 3.3x higher than the last time the gold stocks traded at recent levels! It makes no fundamental sense whatsoever for gold stocks to trade as if gold was at $350 when it was actually $1150. Their core fundamentals are now vastly better.”

The analysis encapsulated in the above excerpts is superficial and misleading, for two main reasons. First, production costs are vastly higher now than they were in 2003-2004. Second, although the stock prices of the senior gold miners are, on average, not much higher now than they were when gold was trading at $350-$400/oz, their market capitalisations are hundreds of percent higher thanks to massive inflation of share quantities. Consequently, a good argument can be made that the “core fundamentals” are now worse than they were when the gold price was $350-$400.

I’ll now consider the specific case of Goldcorp (GG) to back-up my point. During the quarter ended 30th September 2003, GG managed to achieve a net profit of $0.13/share, a net operating margin of 44% and a return on invested capital (ROIC) of 22%. These results were achieved at an average realised sale price of $364/oz. During the quarter ended 30th September 2014 GG’s average realised sale price was $1266/oz, but the company reported a net LOSS of $0.05/share and was too embarrassed to highlight the ROIC. Note that there were no large asset writedowns in the latest quarter. GG was simply not profitable at $1266/oz in Q3-2014 after being very profitable at $364/oz way back in Q3-2003. And by the way, from Q3-2003 to Q3-2014 GG’s share count rose from 183M to 814M, so although its share price is up by ‘only’ about 50%, its market cap is up by about 580% over the period in question.

I selected GG for my quick-and-dirty case study because it has been one of the best-managed of the senior gold producers and has had less company-specific problems than some of its brethren. Had I chosen either Barrick Gold (ABX) or Kinross Gold (KGC) my point could have been made even more clearly, because the amount of wealth destroyed by these companies via ill-conceived acquisitions and project developments is mindboggling.

It’s important that fundamentals-oriented speculators who buy gold-mining stocks have their eyes wide open and understand the reality of the current situation. There are some good reasons to anticipate large gains in gold-stock prices over the coming 2 years involving a rising gold price, declining production costs and improving sentiment, but at the current gold price and with their current cost structures most gold producers are NOT particularly cheap by traditional valuation standards.

Therefore, don’t be hoodwinked by superficial comparisons into believing that gold stocks are now priced for a hundreds-of-dollars-per-ounce lower gold price and, as a consequence, that massive gains lie ahead for gold stocks even if the gold price flat-lines or continues to trend downward.

The historical record indicates that the gold-mining sector performs very well during the first 18-24 months of a general equity bear market as long as the average gold-mining stock is not ‘overbought’ and over-valued at the beginning of the bear market. Unfortunately, the historical sample size is small. In fact, since the birth of the current monetary system there have been only two relevant cases.

The first case involves the general equity bear market that began in January of 1973 and continued until late-1974. This bear market resulted in peak-to-trough losses of around 50% for the senior US stock indices.

The following chart comparison of the Barrons Gold Mining Index (BGMI) and the S&P500 Index shows that the gold-mining sector commenced a strong upward trend near the start of the general equity bear market. During the bear market’s first 20 months, the BGMI gained about 300%.

The second case involves the general equity bear market that began in September of 2000 and continued until early-2003. This bear market also resulted in peak-to-trough losses of around 50% for the senior US stock indices.

The following chart comparison of the HUI and the NYSE Composite Index (NYA) shows that the gold-mining sector commenced a strong upward trend about 2.5 months after the start of the general equity bear market. Despite the fact that the HUI suffered a substantial percentage decline during this 2.5-month period, it still managed to gain about 200% over the course of the bear market’s first 20 months.

The gold-mining sector is currently a long way from being ‘overbought’ and over-valued. In fact, by some measures it was recently as ‘oversold’ as it ever gets. The historical cases cited above would therefore be relevant if a general equity bear market were to begin in the near future.

On a related matter, the only times when the owners of gold-mining stocks need to fear a general equity bear market are those times when the gold-mining sector has trended upward with the broad stock market during the 6-12 months prior to the start of the general equity bear market. Consequently, in the unlikely event that the current bull market in US equities continues for one more year and gold-mining stocks trend upward during that year, the gold-mining sector will then be vulnerable to the downward pull of a general equity decline.

There is an excellent interview about China in the latest edition of Barrons magazine. The interviewee is Anne Stevenson-Yang, who, having spent the bulk of her professional life in China since first arriving in 1985, is extremely well-informed on the topic. She is fluent in Mandarin and is currently the research director of J Capital, a company that works for foreign investors in China doing fundamental research on local companies and tracking macroeconomic developments. Anyone interested in finding out what’s really going on in China should click the above link and read the full interview, but here are some excerpts:

“People are crazy if they believe any government statistics [such as the 7%+ GDP growth figures], which, of course, are largely fabricated. In China, the Heisenberg uncertainty principle of physics holds sway, whereby the mere observation of economic numbers changes their behavior. For a time we started to look at numbers like electric-power production and freight traffic to get a line on actual economic growth because no one believed the gross- domestic-product figures. It didn’t take long for Beijing to figure this out and start doctoring those numbers, too.

I put much stock in estimates by various economists, including some at the Conference Board, that actual Chinese GDP is probably a third lower than is officially reported. And as for the recent International Monetary Fund report calling China the world’s biggest economy on a purchasing-power-parity basis, how silly was that? China is a cheap place to live if one is willing to eat rice, cabbage, and pork, but it’s expensive as all get out once you factor in the cost of decent housing, a car, and health care.

I’d be shocked if China is currently growing at a rate above, say, 4%, and any growth at all is coming from financial services, which ultimately depend on sustained growth in the rest of the economy. Think about it: Property sales are in decline, steel production is falling, commercial long-and short-haul vehicle sales are continuing to implode, and much of the growth in GDP is coming from huge rises in inventories across the economy. We track the 400 Chinese consumer companies listed on the Shanghai and Shenzhen stock markets, and in the third quarter, their gross revenues fell 4% from a year ago. This is hardly a vibrant economy.”

And:

“The giant government economic-stimulus programs since 2008 are rapidly losing their effectiveness. The reason is simple. Much of the money has been squandered in money-losing industrial projects and vanity infrastructure spending that make no economic sense beyond supplying temporary bump-ups in GDP growth. China is riding an involuntary credit treadmill where much new money has to be hosed into the economy just to sustain ever-mounting bad-debt totals. Capital efficiency, or the amount of capital it takes to generate a unit of GDP growth, has soared as a result.”

And:

“The Chinese home real estate market, mostly units in high-rise buildings, is truly bizarre. Many Chinese regard apartments as capital-gains machines rather than sources of shelter. In fact, there are 50 million units in China that are owned but vacant. The owners won’t rent them because used apartments suffer an immediate haircut in value.

It’s as if the government created a new asset class that no one lives in. This fact gives lie to the commonly held myth that the buildout of all these empty towers and ghost cities is a Chinese urbanization play. The only city folk who don’t own housing are the millions of migrant laborers continuously flocking to Chinese cities. Yet, they can’t afford the new housing.”

And:

“All of China’s major corporations are speculating on residential real estate with either cash reserves or borrowed money. Who wants to build, say, a shipbuilding plant when a company thinks it can make a lot more speculating in the housing market?”

And:

“…liquidity seems to be a growing problem in China. Chinese corporations have taken on $1.5 trillion in foreign debt in the past year or so, where previously they had none. A lot of it is short term. If defaults start to cascade through the economy, it will be more difficult for China to hide its debt problems now that foreign investors are involved. It’s here that a credit crisis could start.”

And:

“As for Xi’s much-ballyhooed anticorruption campaign inside China, it offends me that international media depict it as a good-governance effort. What’s really going on is an old-style party purge reminiscent of the 1950s and 1960s with quota-driven arrests, summary trials, mysterious disappearances, and suicides, which has already entrapped, by our calculations, 100,000 party operatives and others. The intent is not moral purification by the Xi administration but instead the elimination of political enemies and other claimants to the economy’s spoils.”

China is an economic disaster happening in slow motion, but it is not a good idea to be short the country’s stock market.

Since coming into existence in 1913, the Federal Reserve has helped facilitate a massive decline in the purchasing power of the US dollar. However, the Fed is not the root of the US monetary problem, as evidenced by the fact that there were several US financial crises/panics during the half-century prior to the establishment of the Fed. As explained by Murray Rothbard (America’s greatest economics historian), these pre-Fed financial panics “were a result of the arbitrary credit creation powers of the banking system.” In other words, the root of the problem is — and has always been — the legal ability of banks to create credit ‘out of thin air’, commonly referred to as fractional reserve banking. With or without a central bank, fractional reserve banking will tend to bring about a boom/bust cycle and thus reduce the long-term rate of economic progress.

Central banking is perhaps history’s best example of government attempting to fix a problem — in this case, the instability resulting from the practice of fractional reserve banking — and making things much worse in the process. The fact that fractional reserve banking leads to periodic crises suggests the following solution: banks should not be allowed to create new money out of nothing, that is, banks should be subject to the same laws as everyone else. However, the big banks tend to be politically influential, and imposing proper restrictions on the banking industry’s ability to expand its collective balance sheet would also restrict the government’s ability to grow, so rather than address the underlying problem the government put in place a system that would enable arbitrary credit creation to continue for much longer and to a much greater extreme without a ‘cleansing’ crisis. In the US, this “system” is called the Federal Reserve. Since the advent of the Federal Reserve there have been longer periods of apparent stability followed by much greater financial crises and economic downturns (the three most severe peace-time economic downturns in the US (the downturns of the 1930s, the 1970s and the 2000s) occurred since the birth of the Fed). There has also been a dramatic increase in the size of the US federal government, with its adverse consequences for freedom.

So, fractional reserve banking caused financial panics and boom-bust economic cycles in the US prior to the creation of the Fed, but crises and recessions in the pre-Fed era were relatively short and the economy tended to recover far more quickly. How, then, do I explain the “great depression” of 1873-1896, which some commentators cite in an effort to ‘prove’ that the Gold Standard doesn’t work and that central banking can be beneficial? 

The short answer is that there was no “great depression” during 1873-1896. Thanks to excessive deposit creation (fractional reserve banking) there were three financial panics during this period (in 1873, 1884 and 1893), but the overall economy achieved very strong real growth. 

For a longer answer I turn to the following excerpts from Murray Rothbard’s “A History of Money and Banking in the United States”:

“Orthodox economic historians have long complained about the “great depression” that is supposed to have struck the United States in the panic of 1873 and lasted for an unprecedented six years, until 1879. Much of this stagnation is supposed to have been caused by a monetary contraction leading to the resumption of specie payments in 1879. Yet what sort of “depression” is it which saw an extraordinarily large expansion of industry, of railroads, of physical output, of net national product, of real per capita income? As Friedman and Schwartz admit, the decade from 1869 to 1879 saw a 3-percent-perannum increase in money national product, an outstanding real national product growth of 6.8 percent per year in this period, and a phenomenal rise of 4.5 percent per year in real product per capita. Even the alleged “monetary contraction” never took place, the money supply increasing by 2.7 percent per year in this period. From 1873 through 1878, before another spurt of monetary expansion, the total supply of bank money rose from $1.964 billion to $2.221 billion — a rise of 13.1 percent or 2.6 percent per year. In short, a modest but definite rise, and scarcely a contraction.

It should be clear, then, that the “great depression” of the 1870s is merely a myth — a myth brought about by misinterpretation of the fact that prices in general fell sharply during the entire period. Indeed, they fell from the end of the Civil War until 1879.

Friedman and Schwartz estimated that prices in general fell from 1869 to 1879 by 3.8 percent per annum. Unfortunately, most historians and economists are conditioned to believe that steadily and sharply falling prices must result in depression: hence their amazement at the obvious prosperity and economic growth during this era. For they have overlooked the fact that in the natural course of events, when government and the banking system do not increase the money supply very rapidly, freemarket capitalism will result in an increase of production and economic growth so great as to swamp the increase of money supply. Prices will fall, and the consequences will be not depression or stagnation, but prosperity (since costs are falling, too), economic growth, and the spread of the increased living standard to all the consumers.”

…”It might well be that the major effect of the panic of 1873 was not to initiate a great depression, but to cause bankruptcies in overinflated banks and in railroads riding on the tide of vast government subsidy and bank speculation.”

…”The record of 1879-1896 was very similar to the first stage of the alleged great depression from 1873 to 1879. Once again, we had a phenomenal expansion of American industry, production, and real output per head. Real reproducible, tangible wealth per capita rose at the decadal peak in American history in the 1880s, at 3.8 percent per annum. Real net national product rose at the rate of 3.7 percent per year from 1879 to 1897, while per-capita net national product increased by 1.5 percent per year.

Once again, orthodox economic historians are bewildered, for there should have been a great depression since prices fell at a rate of over 1 percent per year in this period. Just as in the previous period, the money supply grew, but not fast enough to overcome the great increases in productivity and the supply of products. The major difference in the two periods is that money supply rose more rapidly from 1879 to 1897, by 6 percent per year, compared with the 2.7 percent per year in the earlier era. As a result, prices fell by less, by over 1 percent per annum as contrasted to 3.8 percent. Total bank money, notes, and deposits rose from $2.45 billion to $6.06 billion in this period, a rise of 10.45 percent per annum — surely enough to satisfy all but the most ardent inflationists.”

“The financial panics throughout the late nineteenth century were a result of the arbitrary credit creation powers of the banking system. While not as harmful as today’s inflation mechanism, it was still a storm in an otherwise fairly healthy economic climate.”

In summary, a 23-year period in which the US economy achieved the strongest real growth in its history is strangely characterised in some quarters as a “great depression”, quite likely because so many economists and historians do not understand that real economic progress puts DOWNWARD pressure on prices. Unfortunately, there is no chance that the next 10 years will be anything like the so-called “great depression” of late 19th Century. We won’t be so lucky.