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.

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

Back in July of last year I pointed out that in a world where official short-term interest rates are close to zero, some short-term market interest rates are also going to be very close to zero, and that, in such cases, interest-rate dips below zero could occur as a result of insignificant price fluctuations. A topical example at the time was “gold backwardation”, meaning the price of gold for immediate delivery moving above the price of gold for future delivery. Gold backwardation is still a topical example and, thanks to the persistence of near-zero official US$ interest rates, is still not significant. What I mean is that the “backwardation” has almost everything to do with the near-zero official short-term interest rate and almost nothing to do with gold supply/demand. So please, gold analysts, stop pretending otherwise!

When the gold market is in backwardation, something called the Gold Forward Offered Rate (GOFO) will be negative. A negative GOFO effectively just means that it costs more for a major bank to borrow gold than to borrow US dollars for a short period. In a situation where the relevant short-term US$ interest rate (LIBOR) is close to zero, why would this be important or in any way strange?

The answer is that it wouldn’t be. What’s strange is an official US$ interest rate pegged near zero. Given this US$ interest rate situation, it is not at all surprising or meaningful that the GOFO periodically dips into negative territory and the gold market slips into “backwardation”.

The charts displayed below illustrate the point I’m attempting to make. The first chart shows the 1-month GOFO and the second chart shows the 1-month LIBOR. Notice that apart from a couple of spikes in one that don’t appear in the other, these charts are essentially identical. The message is that GOFO generally tracks LIBOR, so with the Fed having effectively pegged LIBOR near zero since late-2008 it would be normal for GOFO to fluctuate around zero and to sometimes be negative.

The upshot is that a negative GOFO (and, therefore, a “backwardated” gold market) would be a meaningful signal if LIBOR were at a more normal level (say, 3%), but with LIBOR near zero it should be expected that GOFO will periodically move below zero. In other words, there won’t be a useful signal from GOFO until official US$ interest rates move up to more normal — or at least up to less abnormal — levels.

Before ending this post, here are two related points on gold-linked interest rates:

First, the Gold Lease Rate (GLR) that you see quoted in various places is equal to LIBOR minus GOFO. It is a derived quantity and not the actual amount that is paid to borrow gold. The actual amount that any gold borrower pays in interest will be negotiated on a case-by-case basis with the gold lender and will NEVER be negative. In other words, although the derived GLR will sometimes go into negative territory, this doesn’t mean that people are being paid to borrow gold.

Second, a lower GOFO implies a higher (not lower) cost to borrow gold. GOFO’s recent dip into negative territory therefore implies that the cost to borrow gold has risen, although the percentage changes have been tiny and, as noted above, the lease rate paid by a specific borrower will generally not be the same as the GLR published by the LBMA and charted at web sites such as Kitco.com.

Here are the charts referenced in a Market Alert email just sent to TSI subscribers.

It is not uncommon for people who make predictions about the financial markets to be right for the wrong reasons, meaning that even though their reasoning turned out to be wrong the market ended up doing roughly what was predicted. Here are two examples that explain what I’m talking about.

The first example involves the popular forecast, during 1995-2000, that the US stock market would continue to be propelled upward by a technology-driven productivity miracle. This reasoning was used by high-profile analysts such as Abby Joseph Cohen to explain why stratospheric valuations would go even higher. As long as the bull market remained intact these analysts were generally held in high regard, but their reasoning was terribly flawed.

Anyone with a basic understanding of good economic theory knows that increasing productivity causes prices to fall, not rise. Furthermore, while it is certainly possible for some individual companies to justifiably obtain higher market valuations by becoming more productive than their competitors, a general increase in productivity will not cause a sustained, economy-wide increase in corporate profitability and will not justify higher valuations for most equities. To put it another way, the main beneficiaries of higher productivity are consumers, not stock speculators and investors in equity-index funds. Consequently, there was never a possibility that rising productivity was behind the 1995-2000 surge in the US stock market. “Rising productivity” was just a story that sounded good to the masses while the market was going up.

Like all bull markets in major asset classes, the bull market in US equities that ended in 2000 was driven by the expansions of money and credit. After the pace of monetary expansion slowed, the bull market naturally collapsed.

The second example involves the forecast, in 2011-2012, that the gold price was destined to fall a long way due to deflation. Regardless of whether your preferred definitions of inflation and deflation revolve around money supply, credit supply, asset prices or consumer prices, there has been no deflation and plenty of inflation over the past 2-3 years, so advocates of the “gold is going to lose a lot of value due to deflation” forecast could not have been more wrong in their reasoning. However, the gold market has performed as predicted!

Rather than being a victim of deflation, gold was a victim of the reality that over the past three years a bout of rampant monetary inflation led to a huge rally in the broad stock market, which, in turn, boosted economic confidence. Ironically, had the reasoning of the “gold to fall due to deflation” group been close to the mark, the gold price would probably have experienced nothing more than a 12-18 month consolidation following its September-2011 peak. This is not because gold benefits from deflation (it doesn’t), but because the combination of economic weakness, declining economic confidence and the actions taken by central banks to address the economic weakness would have elevated the investment demand for gold.

I’ve noticed that fundamentals-based analysis is rarely questioned if it matches the price action and, by the same token, is often greeted with skepticism if it is in conflict with a well-established price trend. During a raging bull market even the silliest bullish analyses tend to be viewed as credible, and after a bear market has become ‘long in the tooth’ even a completely illogical or irrelevant piece of analysis will tend to be viewed as smart, or at least worthy of serious consideration, if its conclusion is bearish. However, from a practical investing perspective, fundamental analysis can be most useful when its conclusions are at odds with the current price trend. The reason is that the greatest opportunities for profit in the world of investing and long-term speculation are created by divergences between value and price.

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

At the beginning of this year, banking behemoth Goldman Sachs (GS) called for gold to end the year at around $1050/oz. I didn’t agree with this forecast at the time and still believe it to be an unlikely outcome (although less unlikely than it was a few months ago), but earlier this year I gave Goldman Sachs credit for at least looking in the right direction for clues as to what would happen to the gold price. In this respect the GS analysis was/is vastly superior to the analysis coming from many gold-bullish commentators.

Here’s what I wrote at TSI when dealing with this topic back in April:

“GS’s analysis is superior to that of many gold bulls because it is focused on a genuine fundamental driver. While many gold-bullish analysts kid themselves that they can measure changes in demand and predict prices by adding up trading volumes and comparing one volume (e.g. the amount of gold being imported by China) to another volume (e.g. the amount of gold being sold by the mining industry), the GS analysts are considering the likely future performance of the US economy.

The GS bearish argument goes like this: Real US economic growth will accelerate over the next few quarters, while interest rates rise and inflation expectations remain low. If this happens, gold’s bear market will continue.

The logic in the above paragraph is flawless. If real US economic growth actually does accelerate over the next few quarters then a bearish view on the US$ gold price will turn out to be correct, almost regardless of what happens elsewhere in the world. The reason the GS outlook is probably going to be wrong is that the premise is wrong. Specifically, the US economy is more likely to be moribund than strong over the next few quarters. It’s a good bet that inflation expectations will remain low throughout this year, but real yields offered by US Treasuries are more likely to decline than rise due to signs of economic weakness and an increase in the popularity of ‘safe havens’ as the stock market trends downward.”

I was right and GS was wrong about interest rates, in that both nominal and real US interest rates are lower today than they were in April. However, it is certainly fair to say that GS’s overall outlook as it pertains to the gold market has been closer to the mark than mine over the intervening period. This is primarily because economic confidence has risen, which is largely due to the continuing rise in the senior US stock indices.

So, regardless of whether or not gold ends up getting closer to GS’s $1050/oz target before year-end (I don’t think it will), I give GS credit for being mostly right for mostly the right reasons over the course of this year to date.

For their part, many gold bulls continue to look in the wrong direction for clues as to what the future holds in store. In particular, they continue to fixate on trading volumes, seemingly oblivious to the fact that for every net-buyer there is a net-seller and that the change in price is the only reliable indicator of whether the buyers or the sellers are the more motivated.

The gold-stock indices and ETFs are getting close to reasonable upside targets for the INITIAL rallies from their October-November crash lows. These targets are defined by resistance at 185-190 for the HUI and 77-80 for the XAU. For GDXJ, the upside target for the initial rally mentioned at TSI was $29, which has already been reached. Actually, the resistance that defines the most realistic initial rally target for GDXJ extends from $29 to $31.50.

The main purpose of this  brief post is to point out that something has just happened that hasn’t happened since the first half of June. I’m referring to the fact that for the first time in more than 5 months, GDXJ has just achieved 3 consecutive up-days.

This is just another small piece of a big puzzle. It is evidence that the current rebound could evolve into something substantial.

The concept that must always be kept in mind when analysing changes in the amount of gold bullion held by the SPDR Gold Trust (GLD), the largest gold bullion ETF, is that these changes can only happen as a result of arbitrage. More specifically, the Authorised Participants (APs) in the ETF will only add gold to the inventory when an arbitrage opportunity is created by the price of a GLD share moving above the net asset value (NAV) of a GLD share and remove gold from the inventory when an arbitrage opportunity is created by the price of a GLD share moving below the NAV of a GLD share.

The addition of the gold involves multiple steps (the short-selling of GLD shares, the purchase of gold bullion, the delivering of gold bullion to the ETF and the creation of new GLD shares that are used to cover the aforementioned short position) that occur almost simultaneously, but the key is that it is a mechanistic process that a) gets initiated by GLD’s market price moving above its NAV and b) serves the purpose of closing the price-NAV gap. Similarly, there are multiple virtually-simultaneous steps involved in the removal of gold from GLD’s inventory (the buying of GLD shares, the short-selling of gold bullion, the redeeming of GLD shares for gold bullion from GLD’s inventory, and the use of the bullion obtained from the inventory to cover the aforementioned gold short position). And again, it is a mechanistic process that a) gets initiated by GLD’s market price moving below its NAV and b) serves the purpose of closing the price-NAV gap.

In the hope of adding clarity I’ll mention two related points.

First, it is not possible for GLD’s gold inventory to be used to cover short positions elsewhere in the gold market except as part of the arbitrage described above.

Second, because GLD holds gold bullion, a change in the price of gold will not necessitate a change in GLD’s inventory. GLD’s shares will naturally track the price of gold without the need to do anything, regardless of how far or how fast the price of gold moves.

That being said, there are times when the buyers of GLD shares become over-eager, causing the market price of GLD to rise relative to the price of gold, and there are times when the sellers of GLD shares become over-eager, causing the market price of GLD to fall relative to the price of gold. This sets in motion the arbitrage described above.

Now, buyers are most likely to become over-eager after the price has been trending higher for a while and sellers are most likely to become over-eager after the price has been trending lower for a while. That’s why the chart presented below shows that major trends in the GLD inventory FOLLOW major trends in the gold price, and why it makes more sense to view 2013′s large decline in GLD’s gold inventory as an effect, not a cause, of the large decline in the gold price.

I start reading a lot more articles about gold than I finish reading. This is because as soon as I read something in an article that reveals a very basic misunderstanding about the gold market, I stop reading. Sometimes I don’t even get past the first paragraph. Life is too short and there is so much to read that I refuse to waste time reading the words of someone who has just demonstrated cluelessness on the topic at hand. Here are some of the ‘red flag’ statements and arguments in a gold-related article that would stop me in my tracks.

1) Treating annual gold mine production as if it were a large part of the supply side of the equation.

In other metals markets it can make sense to treat new mine supply as if it were a proxy for total supply, but in the gold market the mining industry’s annual production is roughly equivalent to only 1.5% of total supply (see my earlier post on this topic). Therefore, as soon as an article starts comparing the amount of gold bought by a country or market segment with the mining industry’s annual production, as if the mining industry’s production was the main way in which gold demand could be satisfied, I stop reading.

2) Misunderstanding the relationship between supply, demand and price.

Many gold-market analyses are unwittingly based on the premise that the law of supply and demand doesn’t apply to gold. What I mean is that a lot of what passes for analysis in the gold market contains comments to the effect that the demand for physical gold rose relative to supply during a period even though the price fell during that period. I stop reading as soon as I see a comment along these lines. The author of the article may as well have held up a big sign that says: “You’re wasting your time reading this because I’m completely clueless”.

The falling price in parallel with rising demand scenario favoured by too many gold-market commentators is absolutely, unequivocally, impossible. If demand is attempting to rise relative to supply, then the price MUST rise. Note that I say “attempting” to rise, because, in a market that is able to clear (such as the gold market), supply and demand will always be the same, with the price changing to whatever it needs to be to maintain the balance. Furthermore, the change in price is the only way to tell whether demand is attempting to rise relative to supply or whether supply is attempting to rise relative to demand. If the price falls over a period then it is an irrefutable fact that demand attempted to fall relative to supply during that period.

On a related matter, many people fall into the trap of confusing trading volume with demand. However, trading volume generally doesn’t imply anything about demand or price.

A change in volume is never an explanation for a price change and is never an indication of whether demand is attempting to rise or fall relative to supply. The reason is that every transaction involves an increase in demand on the part of the buyer and an exactly offsetting decrease in demand on the part of the seller.

3) The selling of “paper gold” explains how the price of physical gold can fall in parallel with surging demand for physical gold.

No, it doesn’t; an increase in the demand for physical gold cannot be satisfied by an increase in the supply of “paper gold”. Regardless of what is happening in the so-called “paper” markets (e.g., the futures market), if the demand for physical gold attempts to rise relative to the supply of physical gold then the price of physical gold will rise to maintain the balance.

Now, you could reasonably argue that the goings-on in the “paper” markets affect the physical market in such a way that the holders of physical gold offer their gold for sale at lower prices than would otherwise have been the case, but this is very different from arguing that the price fell while demand increased relative to supply. For anyone who cares about logic and who understands the most basic law of economics, the latter argument is nonsense.

4) Adding up the flows of gold between different geographic regions or between different parts of the market as if the resultant information could explain past price movements and predict future price movements.

This is a corollary to item 2). It involves making the mistake of treating trading volume as a fundamental driver of price. In popular gold market analyses, this mistake most often manifests itself as treating the flow of gold into China as if it were a hugely bullish fundamental.

Think of the gold world as containing only two traders called China and World-Excluding-China (WEC). If WEC becomes a net seller of gold, then China must become a net buyer of gold to the same extent. The question is: How far will the price have to fall before China is prepared to buy all the gold that WEC wants to sell or WEC’s desire to sell is sufficiently reduced to restore balance? By the same token, if WEC becomes a net buyer of gold, then China must become a net seller of gold to the same extent. The question then becomes: How far will the price have to rise before China is prepared to sell all the gold that WEC wants to buy or WEC’s desire to buy is sufficiently reduced to restore balance?

The answers to such questions are never known ahead of time. In any case, the point is that flows of gold from one part of the world to another convey little or no information about price, so why do so many gold-market analysts fixate on them?

5) Presenting intra-day price charts showing sharp ‘inexplicable’ declines to make the case that the gold price is being manipulated downward.

This counts as misinformation by omission, as even during a downward trend there will be roughly as many sudden and ‘inexplicable’ intra-day price rises as there are price declines. This has been demonstrated by “Kid Dynamite” HERE and in the related articles at the bottom of the linked post. (Note: In case it isn’t obvious, Kid Dynamite is not attempting to show that the gold price is being manipulated upward. With tongue firmly planted in cheek, he is attempting to show that similar ‘evidence’ used to support the downward manipulation case can be used to support an upward manipulation case.)

You should ask yourself why some bloggers and newsletter writers only show you the intra-day downward spikes. Are they unaware of the upward spikes, or are they trying to mislead you?

I was just sent THIS LINK (thanks Richard) to a very interesting article. Actually, the entire web site (Capitalist Exploits) looks like it would be worth exploring, but at this stage I’ve only read the one article.

The article shows the average annual 3-year returns from a bombed-out sector, industry and country. For example, it points out that stock-market sectors that have fallen by 80% from their highs have, on average, achieved a nominal return of 172% per year over the ensuing 3 years.

With GDXJ having suffered a peak-to-trough shellacking of 87%, this has relevance to the gold-mining sector.

The gold sector’s 2-3 year risk/reward is phenomenally attractive, regardless of whether or not gold’s long-term bull market is intact. However, it would be unwise to attempt to take advantage of this exceptional intermediate-to-long-term profit potential via leveraged ETFs. I explained why in a previous post.

I went to Hong Kong last weekend to get a first-hand look at the protests that are now commonly referred to as the “Umbrella Movement”. I went there believing that the protest movement had very little chance of achieving its main objective, which is to gain a ‘free and fair’ election process for Hong Kong, and came away with the same opinion.

The current protests are taking place in three parts of HK — in the streets around the central government offices in Admiralty (near Central on Hong Kong Island), along part of Nathan Road in Mong Kok (a major shopping area on the Kowloon side of HK), and Causeway Bay (a popular shopping/tourist area on Hong Kong Island). Protestors have blocked off some main streets using makeshift barricades and set up camp.

This must be one of the most peaceful mass protests ever. There are thousands of tents on the streets in the protest areas, but apart from numerous signs demanding “civil nomination” for political office and a few people giving speeches to small crowds at night-time, it doesn’t even seem like a protest. Rather, it seems as if a tent-dwelling community decided to make a home in the middle of a bustling metropolis. There are first-aid tents, covered study areas with many desks so that the students participating in the protest can keep up with their schoolwork, food and drink distribution points, and basic toilet/shower facilities. Also, the occupied areas are kept clean and tidy (there is no rubbish lying around). There was a police presence at Mong Kok (a few dozen uniformed police men and women were standing around the outside of the protest area looking bored), but not at Admiralty.

Here are some of the photos I took.

These photos show the tent cities:

These photos show what is now known as “Lennon Wall”. The wall is part of an elevated road in Admiralty and is coated with countless thousands of messages of support.

Finally, these photos show a first-aid tent, two covered study areas, and examples of the protestors’ artwork:

Overall, it appears to be business as usual in HK. Most people are going about their daily lives as if nothing out of the ordinary is going on, and Hong Kong has adjusted to having no vehicular access to the parts of the city occupied by the protestors. However, the situation could turn ugly, as it did for a few days in September, if the government makes another attempt to forcibly remove the protestors.

Although I couldn’t gauge the general level of support for the protest movement within the HK population, I suspect that most HK residents do not want to ‘rock the boat’ for the sake of greater political freedom. Furthermore, there is clearly some animosity towards the protestors on the part of HK people whose businesses have been disrupted by having some main streets blocked off. In one case, this animosity took the form of a high-volume tirade from a taxi driver when he was asked by my wife for his opinion about the protests.

Hong Kong’s rapidly-rising cost of living is one of the root causes of the discontent that led to the mass protests, but this problem would almost certainly not be addressed by ‘the people’ gaining more influence over who occupies the top political offices. The reason is that hardly anyone involved in the protest movement understands that the high cost of living is due to HK being crushed between the inflationary policies of the US and China.

Thanks to the HK dollar’s peg to the US dollar, HK’s monetary authority essentially follows the US Federal Reserve. This means that despite the steep upward trend in HK prices, interest rates are still being held near zero and the money supply is still being inflated at a brisk pace (it is up by 15% over the past 12 months). At the same time, as a result of the appreciation of the Yuan relative to the US$ and the large price rises in China’s major cities courtesy of rampant monetary inflation in that country, prices in HK still appear reasonable to the mainland Chinese who continue to flood into HK to spend money.

Hong Kong’s “inflation” problem looks destined to get worse over the coming 12 months, which could lead to more widespread support for the “Umbrella Movement”. But in the absence of a general understanding of the nature of the problem, taking a step in the direction of democracy is not going to help.

The gold mining sector entered crash mode last Wednesday (29th October). These types of events typically last 5-6 trading days, although they are sometimes a little shorter and sometimes a little longer. Based on the typical length of a multi-day crash the most likely time for a low is therefore this Tuesday (day 5) or Wednesday (day 6).

It is not uncommon for a multi-day crash to be interrupted by one ‘up day’. For example, a 6-day crash could entail three down days followed by an up day and then two more down days to complete the decline. Monday’s bounce in the gold-mining indices and ETFs is therefore not evidence that the crash is over. However, another advance of at least a few percent on Tuesday 4th November would be evidence that the crash is over.

Incredibly, both the Central Fund of Canada (CEF) and the Central Gold Trust (GTU) are now trading at discounts to their net asset values of almost 10%. This means that purchasing CEF near its current price is roughly equivalent to paying $1050/oz for gold and $14.50/oz for silver. The unusually large discounts at which these bullion funds are now trading is an indication that gold and silver are almost as out-of-favour as they ever get.

This topic was recently revisited at TSI due to the growing popularity of ETFs that are designed to move each day by 2 or 3 times the amount of a target index. My main point was/is that leveraged ETFs should only ever be used as short-term trading vehicles, because they tend to leak value over time. This is not a design flaw; it’s just something that anyone who trades these ETFs should be well aware of. Here is a slightly modified version of the most recent TSI coverage of the issue.

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. For example, if you believe that the S&P500 Index is going to fall by 30% over the coming 12 months and to profit from this expected decline you purchase SDS, an ETF designed to move each day by 2-times the inverse of the SPX’s percentage change, then you will probably not make a 60% profit on this trade even if you turn out to be totally correct about the SPX’s performance. Instead, the amount of profit you make will be determined by the path taken by the SPX on its way to the 30% loss and will probably be a lot less than 60%.

The easiest way for me to explain how the relationship between the daily percentage change of an index and the daily percentage change of an associated leveraged ETF does not translate into a similar relationship over periods of longer than one day, is via some hypothetical examples that show how the math works. Here I go.

In the tables presented below, Index A is the target index (the index for which leveraged exposure is created) and 100 is the starting (Day 0) value for both the index and the associated leveraged ETF. I then move the index up on one day and down by the same amount on the next day, such that by Day 6 it is still at 100.

In the first table, Index A alternately moves up by 10 points and down by 10 points, ending Day 6 back where it started (at 100). The final column in this table shows the value of an ETF designed to move each day by twice the percentage change of Index A. Even though Index A ended the 6-day period unchanged, the 2X ETF based on Index A ended the period with a loss of 5.4%.

In the second table the volatility is ramped up. Instead of Index A alternately moving up and down by 10 points it experiences 20-point daily swings, but still ends Day 6 back where it started (at 100). Even though Index A ended the 6-day period unchanged, in this case the 2X ETF based on Index A ended the period with a loss of 18.7%.

In the third and final table I go back to the 10-point daily swings, but change the leverage to 3-times. In this case, the unchanged result for the index was accompanied by a loss of 15.5% for the leveraged ETF.

An implication of the above is 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. So, it is fair to say 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.

My final point is that it is possible to take advantage of the value leakage inherent in the design of leveraged ETFs by shorting them rather than buying them. For example, if you want to use a leveraged ETF to profit from an expected decline in the S&P500 Index, you will generally be better served by going short SSO (ProShares Ultra Long S&P500 Fund) than by going long SDS (ProShares Ultra Short S&P500 Fund). For another example, if you want to use a leveraged ETF to profit from an expected rise in junior gold-mining stocks and you plan to hold the position for more than a few weeks, you will generally be better served by going short JDST (Junior Gold Miners Index Bear 3X) than by going long JNUG (Junior Gold Miners Index Bull 3X).

TSI subscribers will soon receive an email alert regarding Thursday’s panic in the gold-mining sector, including brief thoughts on what it means for the days ahead and the actions that I am planning to take. The purpose of this post is to highlight the starkly contrasting long-term charts of the HUI and the US$ gold price. The relevant charts are displayed below.

There was already a dramatic difference between the HUI and gold charts prior to this week, but the price action of the past two trading days has magnified the difference. The HUI is now slightly below its 2004 and 2005 lows, and is within spitting distance of its 2008 crash low. At the same time, gold hasn’t even breached its lows of the past year and is trading about 220% above its 2004 low.

I think that the HUI’s position relative to gold equates to one of the most extreme market sentiment situations ever. It is, I think, right up there — in terms of magnitude, but at the opposite end of the sentiment spectrum — with the March-2000 upside blow-off in the NASDAQ.

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.

If you are in the position of needing a market to do something specific in the short term, such as rally or decline by a certain amount, then you are positioned wrongly. You should be positioned in such a way that you can watch the day-to-day price moves with equanimity. Furthermore, unless you make a living from scalping small profits from intra-day fluctuations, you should NOT watch the markets closely during the trading day. No good will come of it, because closely watching the intra-day price action will increase the risk that you will make a spur-of-the-moment decision based primarily on emotion. That is, it will increase the risk of making a mistake.

Before a market in which you have a financial interest opens for trading you should know the prices at which you would be a buyer and the prices at which you would be a seller. You should therefore be able to place any orders prior to the open. You can then check back later — ideally, after the market has closed — to see what happened and which, if any, of your orders were filled.

I feel fortunate to be separated by 12 hours from the stock markets in which most of my stocks trade (the US and Canadian stock markets). This separation removes any temptation that I might otherwise feel to watch the intra-day trading action, because it means that I am usually asleep during the bulk of the trading day.

On a typical day (night) I check the futures markets and company-specific news well before the start of the North American trading session and decide what, if any, new orders are appropriate. Most orders are placed prior to the open, although occasionally I watch the first few minutes of trading before placing an order. I then usually check back after about one hour to see what’s happening before switching off for the night. By the time I switch back on the markets are closed and I can calmly (most of the time) assess the day’s outcome and start thinking about what new orders make sense for the next day.

On a related matter, the majority of the orders I place are either priced well above the market (for sell orders) or well below the market (for buy orders), with the bid and offer prices usually determined by a combination of valuation and chart-related support/resistance. As a result, my orders sometimes sit around for at least a few weeks before getting filled and sometimes don’t get filled at all. I never, ever, use market orders.