In TSI commentaries since May-June last year I have been tracking the current performance of the gold mining sector with its performance during the mid-1980s. More specifically, I have been comparing the current HUI with the mid-1980s Barrons Gold Mining Index (BGMI). The chart that illustrates this model is displayed below.

The model predicted the rapid rise in the HUI during June-August of last year, the steep correction from a peak by early-September to an October-November low, the rise to a new multi-year high by January-2020 and the crash to a low in March-2020. The big predictions associated with this model are now in the past, which is why I can take the liberty of including it in a free blog post.

The main point I want to make with this post is that even though the present often looks very different from any previous time, the bulk of what happens in the financial markets has happened before. It’s often just a matter of finding the right historical comparison, which is always easier said than done. Also, valid comparisons with previous times always have limited lifespans. It’s possible, for example, that my comparison with the mid-1980s has almost reached the end of its useful life.

Knowledge of how markets have performed in the past, including the distant past (not just the preceding 10-20 years), is useful even if it doesn’t lead to a specific history-based model. For example, anyone with knowledge of market history knows that when the gold mining sector is stretched to the upside near the start of a general stock market crash, it always crashes with the broad market. As far as I know, there have been no exceptions.

History informs us that after a crash comes a rebound and after a rebound there is usually a test of the crash low.

[This blog post is a modified excerpt (with an updated chart) from a TSI commentary published one month ago]

Last July the gold/silver ratio came within 10% of its 50-year high, which was reached in 1991, and within 15% of its multi-century high, which was reached in the early 1940s. The following monthly chart from goldchartsrus.com shows that on a monthly closing basis the ratio has just made a new multi-decade high and is now within 10% of a 300-year high, meaning that silver has almost never been cheaper relative to gold than it is today.

One way to interpret the gold/silver ratio chart is that silver has huge upside potential relative to gold. I think this interpretation is correct, but there is a realistic chance that the ratio will make a new multi-century high (in effect, a new all-time high) before silver embarks on a major upward trend relative to gold.

This is not my preferred scenario, but a new all-time high in the gold/silver ratio could occur within the next 12 months due to a major deflation scare.

My current expectation is that over the bulk of this year there will be US dollar weakness and signs of increasing “inflation”, which is a financial/economic landscape that would favour silver over gold and pave the way for some mean reversion in the gold/silver ratio. However, if the stock market bubble were to burst, economic confidence probably would tank and there would be a panic towards ‘liquidity’. For the general public that would involve building-up cash, but for many large investors it would involve buying Treasury bonds and gold. Silver eventually would benefit from the strength in the gold market, but the silver market is not big enough and liquid enough to accommodate investors who are in a hurry to find a safe home for billions of dollars of wealth. Initially, therefore, the gold/silver ratio could rise sharply under such a scenario.

The scenario described above would lead to panic at the Fed, eventually resulting in the introduction of the most aggressive asset monetisation scheme to date. That’s the point when silver probably would commence a major catch-up move.

A 23rd February blog post by Sven Henrich hits a couple of nails on the head. Here’s an excerpt:

“…the virus…clearly has a short term effect, but rather the broader risk is the excess created by ultra-loose monetary policies that has pushed investors recklessly into asset prices at high valuations while leaving central bankers short of ammunition to deal with a real crisis. There was no real crisis last year, a slowdown yes, but central bankers weren’t even willing to risk that, instead they went all in on the slowdown. It is this lack of backbone and co-dependency on markets that has left the world with less stimulus options for when they may be really needed. Reckless.”

Yes, central banks present a vastly greater threat to the economy than the coronavirus. Unfortunately, however, there never will be a vaccine that could immunise the economy from the effects of interest rate manipulation. Also, Sven is wrong when he writes that central bankers are short of ammunition and when he implies that stimulus options of the central planning kind will be needed at some point in the future. These options are always counter-productive and therefore never needed.

Central banks are a long way from being short of ammunition, because there effectively is no limit to the amount of money they can create. They can monetise (purchase with money created out of nothing) pretty much anything. At the moment they generally have restricted themselves to the monetisation of their own government’s debt, but they could expand their bond-buying to encompass investment-grade corporate debt and, if that wasn’t deemed sufficient, high-yield (junk) debt. They also could monetise equities, perhaps beginning with ETFs and working their way down to individual stocks. If they wanted, with a change of some arbitrary rules they could even monetise commercial and residential real estate.

It could be argued that “inflation” (in the popular sense the word: an increase in the so-called general price level) limits the amount of new money that central banks can create, in that after “inflation” starts being perceived as a major threat the central bank will come under irresistible political pressure to tighten the monetary reins. This is one of the tenets of the idiocy known as Modern Monetary Theory, or MMT for short. According to MMT, the government should be able to create out of thin air whatever money it needs, with the “inflation” rate being the only limitation. However, in some developed countries, including the US, many people already are having trouble making ends meet due to the rising cost of living, and yet the central bank claims that the “inflation” rate is too low and senior politicians agree.

As well as distorting price signals and thus getting in the way of economic progress, when the central bank makes long-term additions to its balance sheet it is, in effect, surreptitiously nationalising part of the economy. For example, the Bank of Japan (BOJ) already has nationalised Japan’s government bond market and is well on its way towards nationalising the market for ETFs (the BOJ owns about 80% of all ETF shares listed in Japan).

The creeping nationalisation of markets is something that is rarely, if ever, mentioned during discussions of current and potential monetary stimulus, but it’s a big problem that looks set to get even bigger.

[This blog post is a modified excerpt from a recent TSI commentary]

The main purpose of the GDP growth numbers and most other economic statistics reported by China’s government is to tell the story that the central committee of the Communist Party wants to tell. In other words, the economic numbers form part of the State’s propaganda.

For example, during the first decade of this century the Party’s objective was to show that the economy was performing in spectacular fashion, so the reported GDP growth numbers were almost never below 8% and regularly above 10%. In more recent years the overriding concern has been to paint a picture of stability and sustainable progress, which has involved reporting consistent GDP growth in the 6%-7% range. Refer to the following chart for more detail. Amazingly, most Western analysts accept these figures as if they were accurate reflections of reality, partly, we suspect, because there is no way to prove that what’s being reported is bogus.

Once in a while, however, something happens that shines a light on the meaninglessness of the official numbers. An example was the claim by China’s government that its economy was still growing at an annualised pace of more than 6% during the worst point of the 2007-2009 global recession. Another example very likely will be the quarterly GDP growth that China’s government reports for the first quarter of this year.

The consensus view in the financial news media appears to be that due to the SARS-CoV-2 virus, China’s GDP growth rate in Q1-2020 will slide from 6%+ to ‘only’ 4%-5%. The reality, however, is that China’s economy could not be growing at the moment. Large sections of the country have been essentially put in lock-down mode, and many factories, restaurants, shops and other businesses have been temporarily closed. Tourism has ground to a halt, home sales have collapsed by 90% and vehicle sales are expected to fall by 50%-80% from the same period last year. In some large Chinese cities, including Shanghai, the government has directed state property owners not to collect rent from small- and medium-sized businesses during February and March.

Other examples of the virus’s dampening effect on economic activity are included in articles published on 13th February at the South China Morning (SCMP) and Caixin. According to the SCMP article:

“Recruitment site Zhaopin said this week that around 10 per cent of firms they surveyed were “on the verge of death”, with around 30 per cent planning job cuts and another 30 per cent saying they could not pay their employees on time.”

Along similar lines, the Caixin article notes:

“Even before the outbreak, many small businesses were already grappling with shrinking sales as China’s economy logged some of its slowest growth in decades. With business now at a standstill during the outbreak, many are facing existential liquidity crises. Large numbers say they are having difficulties just paying salaries, adding they can only survive for a matter of months using their current resources, even if Beijing provides support.”

It should be obvious to anyone with at least rudimentary knowledge of the world that China’s economy is contracting right now. Therefore, if the government reports GDP growth of 4%+ for the first quarter of this year it will be a tacit admission that the official numbers are totally fictitious. By the same token, to retain any semblance of credibility China’s government will have to admit that its economy shrank during the first quarter of this year.

That’s why China’s next quarterly GDP number will be a test.

In a TSI commentary last November I wrote about adjustments I was making to my stock selection process. These adjustments weren’t due to issues with any individual stock(s) or the performance of any individual stock-market sector. In particular, the poor performance of the average junior gold-mining stock during 2019′s gold rally wasn’t the primary driver of my decision to make some changes, although it was the proverbial “last straw”. The primary basis for my adjustment was evidence that the investing landscape had changed in a permanent, or at least a semi-permanent, way.

Long-term changes in the investing landscape happen from time to time, that is, the future is not always a simple extrapolation of the past. This occurs not because of a change in human nature (human nature never changes), but because of a change in the monetary system. For example, the investment strategy that involved shifting from equities to bonds when the stock market’s average dividend yield dropped below the average yield on investment-grade bonds worked without fail for generations prior to the mid-1950s, but from the mid-1950s onward it didn’t work. The reason this ‘fail safe’ approach to asset allocation stopped working was the increasing propensity/ability of central banks to inflate the money supply.

As part of their attempts to encourage more borrowing and consumption, over the past few years the major central banks manipulated interest rates down to unprecedented levels. Ten years ago very few people thought that negative nominal interest rates were possible, but in 2019 we reached the point where 1) a substantial portion of the developed-world’s government debt was trading with a negative yield to maturity, 2) some corporate bonds had negative yields to maturity, and 3) banks in some European countries were offering mortgages with negative interest rates.

Due to the draconian efforts of central banks to promote more spending and borrowing, it’s possible that the public is now effectively ‘tapped out’. This would explain why the quantity of margin debt collapsed over the past 18 months relative to the size of the US stock market, something that NEVER happened before with the S&P500 in a long-term bullish trend and regularly making new all-time highs. Also, it would explain why the average small-cap stock (as represented by the Russell2000) is trading at a 16-year low relative to the average large-cap stock (as represented by the S&P500).

Linked to the relatively poor performance of the average small-cap stock is the increasing popularity of passive investing via indexes and ETFs. Over the past several years there has been a general decline in the amount of active, value-oriented stock selection and a general rise in the use of ETFs. This has caused the stocks that are significant components of popular ETFs to outperform the stocks that are not subject to meaningful ETF-related demand, regardless of relative value. There is no reason to expect this trend to end anytime soon. On the contrary, the general shift away from individual stock selection and towards the use of ETFs appears to be accelerating.

At this stage I’m not making dramatic changes to my stock selection approach. I will continue to follow speculative small-cap stocks, but my selection process will be more risk averse and I will reduce the potential tracking error during intermediate-term rallies in mining stocks by putting more emphasis on ETFs and mutual funds. Also, when making future speculative mining-stock selections I will pay greater heed to the attractiveness of the assets to large mining companies. The reason is that regardless of the public’s willingness to speculate, large mining companies will always be under pressure to replace their depleted reserves and add new reserves. The easiest way for large companies to do this is to buy small companies that have discovered mineral deposits of sufficient size and quality.

In summary, as a result of unprecedented manipulation of money and interest rates it’s possible that some of the investing/speculating strategies that worked reliably in the past will not work for the foreseeable future. I think it makes sense to adapt accordingly.

[This blog post is an excerpt from a TSI commentary published on 26th January 2020]

Given the extent to which the US stock market is stretched in both momentum and sentiment terms, there doesn’t have to be a news-related catalyst for a significant correction. However, the mainstream financial press tries to link every move in the stock market to the current news. If a correction began last week or gets underway this week it’s likely that many fingers of blame will point to the Wuhan virus.

The situation is ‘fluid’, but at last count 13 Chinese cities had been placed under full or partial lockdown in an effort to prevent the virus from spreading. Furthermore, the number of countries with confirmed cases of the virus is growing.

In terms of global economic impact we think that the Wuhan virus will prove to be a minor issue, but if the number of confirmed cases continues to rise then many market participants could sell first and ask questions later. Based on what happened with similar viruses in the past, the number of confirmed cases might not peak until March.

Blame for a correction also could be directed towards the Fed, largely due to a misunderstanding of the Fed’s “repo market” operations.

The net amount of ‘liquidity’ provided by the Fed to the repo market has declined over the past couple of weeks, but not because the Fed has stopped supporting this market. The money provided to the repo market is a very short-term loan that often matures within one day, so the amount of repo money provided by the Fed will reduce over time unless the Fed adds new money (makes new loans) at a rapid pace. For example, the Fed ‘pumped’ (loaned) $74 billion into the repo market last Thursday, but there was a net decline of $10 billion on the day due to the expiration of $84 billion of previous loans.

Also worth mentioning is that the amount of money provided by the Fed to the repo market cannot exceed the demand for short-term loans in this market.

We assume that the Fed intends to withdraw from the repo market over the coming months, with the very short-term money it provides via this market steadily being replaced by the semi-permanent money it adds via the asset monetisation program — the program that we aren’t supposed to call QE, even though it is mechanically identical to QE — introduced last October. If this happens it will result in a large decline in the “Repurchase Agreements” line on the Fed’s balance sheet and could result in a small decline in the total size of the Fed’s balance sheet, but it won’t be a sign that the Fed is tightening or even becoming less easy.

To further explain, note that even though many commentators lump the Fed’s repo market support program together with the Fed’s asset monetisation program to arrive at a total amount of new Fed-generated monetary inflation, the two programs are very different and should not be combined. The reason is that despite “repo” being short for repurchase, repo operations do not involve asset purchases per se. When the Fed does a “repo” it lends money (that it creates out of nothing) to a borrower and receives collateral, usually in the form of a Treasury security or a Mortgage-Backed Security (MBS), to secure the loan. When the loan is repaid, which happens one or fourteen days later depending on whether it’s an overnight loan or a term loan, the money is returned to the Fed (and is immediately extinguished) and the collateral is returned to the borrower.

Any monetary inflation caused by the Fed’s repo operations is therefore self-extinguishing within a very short time (1-14 days). However, monetary inflation caused by the Fed’s asset monetisation program could be permanent. The reason is that although the debt securities (T-Bills) purchased by the Fed with new money will mature within a few months, the Fed has said that it will re-invest (rather than extinguish) the proceeds received when the securities mature.

The upshot is that even if the total size of the Fed’s balance sheet reduces as the repo support program winds down, as long as the Fed is adding ‘permanent’ money via its asset monetisation program it is acting in an inflationary manner. Consequently, it will not be reasonable to blame a near-term stock market downturn on the Fed becoming tighter or less easy.

Just to be clear, the Fed is at least partly responsible for the fact that the stock market rose in a virtual straight line from mid-October through to 23rd January. However, the Fed is not responsible for the market pulling back from an overbought/overbullish extreme.

The crux of the matter is that regardless of the fundamentals, large and liquid markets don’t go up or down in straight lines for long. There are always corrections. Surely we don’t have to rack our brains in an effort to come up with a fundamental reason for a correction when some short-term sentiment and momentum indicators are stretched to historic extremes. It’s more of a challenge to explain why a correction didn’t happen sooner.

Do gold mining stocks, as represented by the Barrons Gold Mining Index (BGMI) or the XAU or the HUI, lead gold bullion at significant turning points? According to many analysts the answer is a resounding “yes”. However, according to the historical record the answer is “sometimes, but not consistently”. I’ll go with the historical record.

There are plenty of examples of gold mining stocks leading the bullion price at a turning point from down to up or up to down, but there are at least as many examples of gold mining stocks lagging the bullion at a turning point. The most blatant example of the latter occurred in 1980. It is well known that gold bullion reached a long-term price top in January-1980, but it is less well known that gold mining stocks, as represented on the following weekly chart by the BGMI, experienced a huge rally after the major high in the gold price and didn’t reach a long-term peak of their own until September-1980.

Another example of gold bullion leading the gold-mining sector at a meaningful turning point occurred during the mid-1980s. First, gold bullion reached a multi-year bottom in February-1985, but it wasn’t until July-1986 that the XAU reached a similar bottom. Second, the XAU commenced an intermediate-term rally in late-July of 1986, but as noted on the following daily chart the associated bottom in the gold price occurred about 6 weeks earlier.

Here are examples of the same lead-lag relationship from the more recent past:

1) Gold bottomed on a long-term basis in early-December of 2015, but the equivalent low for the HUI didn’t occur until mid-January of 2016. Gold then reached an intermediate-term top in July-2016, but the associated top for the HUI wasn’t put in place until about a month later. In other words, the gold-mining sector lagged the bullion market at both the start and the end of the 2016 intermediate-term rally.

2) Gold made an intermediate-term bottom in August-2018, whereas the HUI waited until September-2018 to make an intermediate-term bottom of its own. Then, in May of 2019 the HUI made a sequence of lower correction lows while gold bullion remained above the low it made at the beginning of the month.

In my experience, rather than labour under the unreliable assumption that gold stocks lead the bullion at turning points, any divergence or non-confirmation between gold stocks and gold bullion should be viewed as potentially bullish after prices have become stretched to the downside and potentially bearish after prices have become stretched to the upside. For example, after prices have been trending downward for several months, a new multi-month low in the gold price that isn’t quickly confirmed by the HUI or a new multi-month low in the HUI that isn’t quickly confirmed by the gold price should be viewed as a bullish sign. By the same token, after prices have been trending upward for several months, a new multi-month high in the gold price that isn’t quickly confirmed by the HUI or a new multi-month high in the HUI that isn’t quickly confirmed by the gold price should be viewed as a bearish sign.

To put it more simply, non-confirmations between the gold price and the related mining indices matter, but it doesn’t matter whether the non-confirmations involve relative strength or relative weakness in the mining sector.

[This post is an excerpt from a recent TSI commentary]

Over the past four months the Fed has added about $400B to its balance sheet. To put this into perspective, since early September the Fed has expanded its balance sheet at an annualised rate of around 30%. According to the Fed, the purpose of this dramatic monetary expansion was to address a temporary liquidity issue in the “repo” market. The question is: If the Fed is dealing with only a temporary shortage of liquidity in the market for short-term money, why did it introduce a program in mid-October to supplement the temporary injections of “repo” money with $60B/month of permanent money?

The answer is that the Fed is dealing with something more than a temporary shortage of liquidity in the market for short-term money. The fact that the Fed sees the need to remove $60B/month of Treasury supply from the market in addition to the Treasury supply that is being removed on a temporary basis via “repo” operations implies that the overall demand for Treasury debt is falling short of Treasury supply at the Fed’s targeted interest rates. Looking from a different angle, it is clear that at current interest rates the global financial system wants more dollars and less Treasury debt. The Fed is accommodating this desire by increasing the supply of dollars to the market and reducing the supply of government debt that must be absorbed by the market.

The key phrase in the above paragraph is “at current interest rates”. If the supply of and the demand for money and credit were permitted to balance naturally then interest rates would now be much higher. However, the Fed doesn’t want supply and demand to strike a natural balance; the Fed has decided that it wants the price of credit at a certain level and that it will use its power to create and destroy money to override natural market forces. In this regard the current situation is unusual only in degree, because the Fed has been attempting to override market forces for more than 100 years.

The US Federal government is not about to slow the pace at which it emits new debt. On the contrary, the rate of growth in government debt supply looks set to rise. Therefore, one of two things will have to happen if interest rates are to stay near current low levels: The Fed will have to keep absorbing Treasury supply at a rapid pace or the market’s desire to hold Treasury debt will have to increase substantially. The latter could occur in response to a sizable decline in the US stock market or a crisis outside the US.

Within a week of its mid-October announcement we wrote that the Fed’s promise to inject $60B/month of new ‘permanent’ money was a potential game-changer, in that it could extend the current cycle (prolong the equity bull market) and lead to more “price inflation” than earlier programs. We continue to think that a cycle extension could be on the cards, but if so the recession warnings that were generated by leading indicators during the second half of last year must disappear within the next couple of months.

[This post is an excerpt from a recent TSI commentary]

Over the past three months the year-over-year rate of growth in US True Money Supply (TMS), a.k.a. the US monetary inflation rate, has jumped from a 12-year low of 1.5% to a 2.5-year high of 6.1%. Refer to the first of the following charts for the details. This is due to the combination of the Fed’s new money-pumping scheme, which we are told is not QE even though it is identical to QE in terms of its effect on bank reserves, the money supply and the financial markets, and the expansion of commercial bank credit at close to its fastest pace in 10 years. The second of the following charts shows the year-over-year rate of change in commercial bank credit. If the commercial banking system continues to expand credit at the current pace and the Fed runs its new asset monetisation program until at least the end of March, then by the third quarter of next year the US monetary inflation rate will be above 10%. What does this mean for the financial markets and the economy?

Once a boom turns to bust there is nothing the Fed can do to stop or even delay the hardship that most people experience during periods of economic recession or depression. There also is very little the Fed can do after the boom-bust transition has occurred to prevent asset prices from tumbling. However, before the boom collapses, as eventually it must, it can be given a second (or a third or a fourth or a fifth) wind by a substantial new injection of money. Therefore, IF the boom is still mostly intact then the strong rebound in monetary inflation could prolong the cycle.

Given that the senior US stock indices are at all-time highs in dollar terms and are yet to signal long-term downward reversals in gold terms, it’s possible that the boom is intact. This means that the rebound in monetary inflation COULD prolong the boom phase of the current cycle. Whether it actually will is not knowable at this time. One of the ‘tells’ will be whether or not there is a sizable pick-up over the next three months in new manufacturing orders.

If the boom phase of the cycle is extended by the monetary inflation rebound it will be bullish for oil, industrial metals and the stocks of cyclical companies (the more cyclical the better), and bearish for gold, T-Bonds and “defensive” stocks.

Like old soldiers, old beliefs never die. In the financial world, one of the many old beliefs that clings to life despite a pile of conflicting evidence is the one about gold being primarily a hedge against, or a play on, so-called “CPI inflation”.

The belief that big moves in the gold price are primarily driven by “price inflation” as measured by the CPI was spawned by what happened during 1972-1982. As illustrated by the following chart, there was a strong positive correlation between the gold price and the 12-month rate of change in the CPI during this period. However, it is clear that the positive correlation of 1972-1982 did not persist over the subsequent 37 years. In particular, the chart shows that the most recent two major rallies in the gold price (the rallies that began in early-2001 and late-2008) had nothing to do with “CPI inflation”. These rallies got underway in the midst of steep declines in the CPI’s growth rate and were at no time supported by a rapidly-rising CPI. The chart also shows that 2019′s significant up-move in the gold price had nothing to do with a rising rate of “CPI inflation”.

All substantial gold rallies are driven by falling confidence in the monetary authorities. The fall in confidence can be associated with so-called “price inflation”, but it certainly doesn’t have to be. As was the case with the major gold rallies that began in 2001 and 2008, it can be associated with stock market weakness, concerns about future economic growth, stresses in the banking system and minimal “price inflation”.

At some point within the next 10 years there could be a major bullish trend in the gold price that is linked to a large rise in the CPI, but that’s not the most likely scenario. There’s a better chance that the next major gold rally will be set in motion by a long-term trend reversal in the US stock market. In fact, even the gold bull market of the 1970s had more to do with a long-term bearish trend in US equities (the US stock market peaked in the late-1960s and bottomed in 1982) than rapid “price inflation”.

Naturally, the US$ gold price will rise over very long (50+ year) periods as the US$ depreciates, but so will the US$ prices of many other assets. Within this group of assets that tend to rise in terms of depreciating currency over the very long term, gold’s unique property is its counter-cyclicality. Gold racks up the bulk of its long-term appreciation during the bust phases of economic cycles.

[This blog post is an excerpt from a recent TSI commentary]

During a gold bull market the “true fundamentals”, as indicated by our Gold True Fundamentals Model (GTFM), will be bullish most of the time. However, even during a bear market there can be periods of a year or longer when the fundamental backdrop is bullish most of the time. This means that the GTFM can’t be used to determine whether gold’s long-term trend is bullish or bearish. The historical sample size is small, but the most important prerequisite for the start of a gold bull market appears to be the start of a bear market in US equities.

That’s why we use a long-term weekly chart of the gold/SPX ratio with a 200-week MA to identify gold bull and bear markets. Unfortunately, at this time the chart (see below) is noncommittal, because gold/SPX bottomed in August of 2018 but is yet to make a sustained break above its 200-week MA. It’s possible that a gold bull market got underway in August of last year, but it’s also possible that we are dealing with a 1-2 year up-swing within a bear market.

The inverse long-term relationship between gold and the US stock market is not always evident over the short-term or even the intermediate-term, although over the past two years it does seem like the gold market and the stock market have been taking turns. This is illustrated by the following chart. The chart shows that there was a net gain in the SPX over the periods when gold trended downward and a net loss in the SPX over the periods when gold trended upward.

The implication is that gold’s next 3-month+ upward trend should unfold over a period in which the SPX generates a poor return (most likely a significant loss).

The following charts relate to an update on the markets that was just emailed to TSI subscribers.

1) Gold

2) The Gold Miners ETF (GDX)

3) The Yen

4) The S&P500 Index (SPX)

5) The Russell2000 ETF (IWM)

6) The Dow Transportation Average (TRAN)

7) The iShares 20+ Year Treasury ETF (TLT)

[This blog post is a modified excerpt from a TSI commentary]

In one important respect, the average central banker is like the average politician. They both tend to focus on the direct and/or short-term effects and ignore the indirect and/or long-term effects of policies. In the case of the politician, this is understandable if not excusable. After all, the overriding concern of the average politician is winning the next election. The desire to be popular also influences the decisions of central bankers, but there is a deeper reason for the members of this group’s shortsightedness. The deeper reason is their unwavering commitment to Keynesian economic theory.

All central bankers are Keynesians at heart (if they weren’t they wouldn’t be central bankers), and Keynesian economic theory revolves around the short-term and the superficial. It’s all about policy-makers in the government and the central bank attempting to ‘manage’ the economy by stimulating demand under some conditions and dampening demand under other conditions, with the conditions determined by measures of current or past economic activity. For example, if certain statistics move an arbitrary distance in one direction then an attempt will be made to boost “aggregate demand”. That the concept of “aggregate demand” is bogus is never acknowledged, because acknowledging that the economy comprises millions of distinct individuals as opposed to an amorphous blob would call into question the entire basis for central control of money and interest rates.

In the short-term, the manipulation of money and interest rates often seems to work. In particular, pumping money and forcing interest rates below where they otherwise would be can lead to increased economic activity in the form of more consumption and more investment. What’s happening, however, is that false signals are causing people to make mistakes.

One problem is that people are incentivised by cheaper credit to consume more than they can afford, which guarantees reduced consumption in the future. The bigger problem, though, is on the investment front, in that projects and businesses that would not be financeable at free-market rates of interest are made to appear economically viable. This could seem like a very good thing for a while, but it means that a lot of resources get used in ventures that eventually will fail. It also means that the businesses that would have been viable in a non-manipulated rate environment suffer profit-margin compression due to the ability, created by the abundance of artificially-cheap credit, of relatively inefficient and/or unprofitable competitors to remain in operation.

In addition to the above, the persistent downward manipulation of interest rates leads to huge pension-fund deficits. However, burgeoning shortfalls in the world of pension funds is a major economic and political issue that deserves separate treatment and is outside the scope of this short discussion. Suffice to say right now that the massive unfunded pension liabilities that have arisen due to the policy of interest-rate suppression could be the excuse for new policies that are even more destructive, such as policies based on Modern Monetary Theory (MMT).

Summing up, the policy of interest-rate suppression promotes resource wastage and general profit-margin compression. It therefore reduces economic growth over the long term. Furthermore, it’s not so much that central bankers weigh the long-term cons against the short-term pros and opt for the latter; it’s that their chosen theoretical framework doesn’t even allow them to consider the long-term cons. That’s how the head of the ECB is able to argue with a straight face that even though euro-zone interest rates have been manipulated well into negative territory, more interest-rate suppression is needed to support the economy.

In a blog post in early-September I noted that the 10-year TIPS (Treasury Inflation Protected Security) yield had just gone negative and that the previous two times that this proxy for the real interest rate went negative (August-2011 and July-2016) the gold price was at an important peak. I then attempted to answer the question: If gold tends to benefit from a lower real interest rate, why would the gold price reverse downward shortly after the real interest rate turned negative?

In the earlier post I gave three reasons why a downward reversal in the gold price could coincide with the ‘real’ interest rate going negative. They were:

1) The dip into negative territory marked a low point for the real interest rate.

2) The real interest rate is just one of several fundamental gold-price drivers, so the upward pressure on the gold price exerted by a falling real interest rate could be counteracted by the downward pressure exerted by other fundamental influences.

3) The gold-bullish fundamental backdrop had been fully discounted by the current gold price.

At the time I thought that the third of the above-mentioned reasons may be applicable, because the speculative net-long position in Comex gold futures was very close to an all-time high and the weekly RSI (an intermediate-term momentum indicator) was almost as high as it ever gets.

As it turned out, the first and third reasons were applicable. Sentiment and momentum indicators pointed to extreme enthusiasm for gold on the part of the speculating community, and the following chart, which is an update of the chart included in the blog post linked above, shows that the 10-year TIPS yield reversed upward at the beginning of September.

The current situation is that neither sentiment nor fundamentals are conducive to substantial strength in the gold price. There could be a counter-trend rebound at any time, but the conditions are not right for a resumption of the major upward trend that got underway in the second half of last year.

In an earlier blog post I discussed the relationship between gold and inflation expectations. Contrary to popular opinion, gold tends to perform relatively poorly when inflation expectations are rising and relatively well when inflation expectations are falling.

The relationship outlined above is very clear on the following charts. The first chart shows that over the past 6 years there has been a strong positive correlation between RINF, an ETF designed to move in the same direction as the expected CPI, and the commodity/gold ratio (the S&P Spot Commodity Index divided by the US$ gold price). In other words, it shows that a broad basket of commodities has outperformed gold during periods when inflation expectations were rising and underperformed gold during periods when inflation expectations were falling. The second chart shows the same comparison over the past 12 months. Notice that inflation expectations bottomed for the year (to date) in mid-August and the commodity/gold ratio bottomed about two weeks later.

A large part of the reason for the strong inverse relationship between gold’s relative strength and inflation expectations is the general view that “inflation” of 2%-3% is not just normal, it is beneficial. In fact, most people have been conditioned to believe that it’s a serious economic problem necessitating draconian central bank intervention if money fails to lose purchasing power at a slow and steady pace.

Eventually the rate of “price inflation” will rise to a level where it starts being seen by the public as a major economic problem, and, as a result, the desire to maintain cash savings will enter a steep decline. It is at this point that the relationship depicted above will stop working and the demand for gold will begin to surge in parallel with rising inflation expectations. In other words, at some point the relationship depicted on the above chart will reverse due to declining confidence in the official money. This point probably will arrive within the next 10 years, but probably won’t arrive within the next 12 months. Over the next 12 months it’s likely that gold will continue to be favoured during periods of falling inflation expectations and other commodities will continue to be favoured during periods of rising inflation expectations.

So, if you think that the recent inflation-expectations bounce is the start of a trend then you should be looking for opportunities to increase your exposure to commodities such as oil and copper, not gold. My guess is that inflation expectations bottomed during August-October of this year, but I’m open to the possibility that the bottoming process will extend into early next year.

In a blog post on 30th September I noted that the banking sector (as represented by the US Bank Index – BKX) had begun to show relative strength, a ramification of which was that my Gold True Fundamentals Model (GTFM) had shifted from bullish to bearish. An update is warranted because the situation has changed since then in a way that is both interesting and a little surprising.

Just to recap, the relative performance of the banking sector (as indicated by the BKX/SPX ratio) is an input to my “true fundamentals” models for both the US stock market and the gold market, the difference being that when the input is bullish for one of these markets it is bearish for the other. In particular, relative weakness in the banking sector is considered to be bullish for gold and bearish for general equities.

As explained in the above-linked post, there was enough relative strength in the banking sector during the first half of September to flip the BKX/SPX input from gold-bullish to equity-bullish, causing the GTFM to shift from bullish to bearish. My guess at the time was that the GTFM would return to gold-bullish territory within the next two months, but I pointed out that it is usually better to base decisions on real-time information than on what might happen in the future.

Within a few days of my 30th September post the GTFM shifted back to bullish, where it remains today. This means that apart from a 3-week period during September, the fundamental backdrop has been supportive for gold since the beginning of this year. Refer to the following chart for more detail (the fundamental backdrop is gold-bullish when the blue line on the chart is above 50). Furthermore, there is evidence in the recent price action that gold’s correction is over. However, the fundamental and technical signs of strength in the gold market were not accompanied by signs of weakness in the banking sector.

What’s both interesting and a little surprising is that the renewed signs of strength in gold have gone hand-in-hand with additional signs of strength in the banking sector. Specifically, since my 30th September post the BKX has broken out to the upside (refer to the top section of the following weekly chart) and the BKX/SPX ratio has broken a sequence of declining tops that dates back to early last year (refer to the bottom section of the following chart).

The BKX/SPX ratio is just one of seven inputs to the GTFM, so there are circumstances in which the gold price can trend upward along with relative strength in the banking sector of the stock market. In other words, it isn’t out of the question that over the next few months we will get a gold rally in parallel with a continuing rise in the BKX/SPX ratio and strength in general equities. It’s more likely, however, that the emerging signs of strength in gold are warning of a short-term reversal to the downside in both the broad stock market and the banking sector.

[This post is an excerpt from a recent TSI commentary]

Once an equity bear market is well underway it runs its course, regardless of the Fed’s actions. For example, the Fed started cutting interest rates in January of 2001, but the bear market that began in March of 2000 continued until October-2002. For another example, the Fed started cutting interest rates in September-2007, but a bear market commenced in October-2007 and continued until March-2009 despite numerous Fed actions designed to halt the price decline. On this basis it can be argued that the Fed’s introduction of a new asset monetisation program roughly one week ago won’t prevent the stock market from rolling over into a major bearish trend. However, there is a good reason to think that it could be different this time (dangerous words, we know) and that the Fed’s new money-pumping scheme will prove to be game-changer.

The reason to think that it could be different this time is that in one respect it definitely is different. We are referring to the fact that although the Fed started cutting interest rates in the early parts of the last two cyclical bear markets (2000-2002 and 2007-2009), it didn’t begin to directly add new money to the financial markets until the S&P500 Index had been trending downward with conviction for about 12 months.

To further explain, when the Fed’s targeted interest rates follow market interest rates downward, which is what tends to happen during at least the first half of an economic downturn, the official rate cuts do not add any liquidity to the financial system. It’s only after the Fed begins to pump new money into the financial markets that its actions have the potential to support asset prices.

During the last two bear markets, by the time the Fed started to pump money it was too late to avoid a massive price decline. This time around, however, the Fed has introduced a fairly aggressive money-pumping program while the S&P500 is very close to its all-time high and seemingly still in a bullish trend.

The Fed has emphasised that the new asset monetisation program should not be called “QE” because it does not constitute a shift in monetary policy. Technically this is correct, but in a way it’s worse than a shift towards easier monetary policy. The Fed’s new program is actually a thinly-disguised attempt to help the Primary Dealers absorb an increasing supply of US Treasury debt. To put it another way, the Fed is now monetising assets for the purpose of financing the US federal government, albeit in a surreptitious manner.

This relates to a point we made in a recent blog post. The point is that when the central bank is perceived to be financing the government, as opposed to implementing monetary policy to achieve economic (non-political) objectives such as “price stability”, there is a heightened risk that a large decline in monetary confidence will be set in motion. One effect of this would be an increase in what most people think of as “inflation”.

Summing up, it’s possible that the Fed’s new asset monetisation program will extend the current cycle (prolong the equity bull market) and lead to more “price inflation” than earlier programs.

[This post is a modified excerpt from a recent TSI commentary.]

We regularly look at what’s happening with monetary inflation around the world, but today we’ll focus exclusively on the US monetary inflation rate. This is because of the recent evidence that the unusually-low level of this long-term monetary indicator is starting to have a significant short-term effect.

The following chart shows that the year-over-year rate of change in US True Money Supply (TMS), a.k.a. the US monetary inflation rate, made a new 12-year low in August-2019. Furthermore, the latest TMS growth figure for the US is very close to the 20-year low registered in September-2006.

Within three months of the TMS growth trough in September-2006 the first obvious crack appeared in the US mortgage debt/securitisation bubble. The crack was a trading update issued by HSBC on 5th December 2006 that noted the increasing “challenges” being faced by the Mortgage Services operations of HSBC Finance Corporation. This initial sign of weakness was followed by the appearance of a much larger crack on 7th February 2007. That’s when HSBC issued another trading update that included a profit warning due to substantially increased loan impairment charges. Within days of this February-2007 HSBC update, the shares of sub-prime lending specialists such as New Century Financial and NovaStar Financial went into freefall. This marked the beginning of the Global Financial Crisis, although the US stock market didn’t top out until October of 2007 and industrial commodities such as oil and copper didn’t top out until mid-2008.

The above-mentioned events could be relevant to the current situation, in that the recent chaos in the US short-term funding market could be the initial ‘crack’ in today’s global debt edifice. While the low rate of US monetary inflation was not the proximate catalyst for the recent chaos, there is little doubt that it played a part. Temporary issues such as a corporate tax deadline and a large addition by the US Treasury to its account at the Fed would not have had such a dramatic effect if the money supply had been growing at a ‘normal’ pace.

Generally, when the money supply is growing very slowly within a debt-based monetary system, a relatively small increase in the demand for cash can create the impression that there is a major cash shortage.

Now, if there’s one thing we can be sure of it’s that the next crisis will look nothing like the last crisis. The financial markets work that way because after a crisis occurs ‘everyone’, including all policy-makers, will be on guard against a repeat performance, making a repeat performance extremely improbable. Therefore, we can be confident that even if the recent temporary seizure of the US short-term funding market was a figurative shot across the bow, within the next couple of years there will NOT be a major liquidity event that looks like the 2007-2008 crisis. However, some sort of crisis, encompassing an economic recession, is probable within this 2-year period.

The nature of the next crisis will be determined by how the Fed reacts to signs of economic weakness and short-term funding issues such as the one that arose a few weeks ago. In particular, quick action by the Fed to boost the money supply would greatly reduce the probability of a deflation scare and greatly increase the risk that the next crisis will involve relatively high levels of what most people call “inflation”.

As an aside, there’s a big difference between the Fed cutting its targeted short-term interest rates and the Fed directly boosting the money supply. For example, in reaction to signs of stress in the financial system the Fed commenced a rate-cutting program in September of 2007, but it didn’t begin to directly pump money into the system until September of 2008. In effect, during the last crisis the Fed did nothing to address liquidity issues until almost two years after the appearance of the initial ‘crack’. As a consequence, the monetary inflation rate remained low and monetary conditions remained ‘tight’ until October of 2008 — 12 months after the start of an equity bear market and 10 months after the start of an economic recession.

Early indications are that the Fed will be very quick to inject new money this time around, partly because 2007-2008 is still fresh in the memory. These early indications include the rapidity of the Fed’s response to the effective seizure of the “repo” market last month and the fact that last Friday the Fed introduced a $60B/month asset monetisation program. This program is QE in everything except name. In other words, the Fed already has resumed Quantitative Easing even though GDP is growing at about 2%/year, the unemployment rate is at a generational low and the stock market is near an all-time high.

In summary, while it is too early to have a clear view of how the next major crisis will unfold, something along the lines of 2007-2008 can be ruled out. Also, there are tentative signs that the next crisis will coincide with or follow a period of relatively high “inflation”.

The events of the past 10 years have fostered the belief that central banks can create a virtually unlimited amount of money without significant adverse consequences for the purchasing power of money. Since the law of supply and demand applies to money similarly to how it applies to every other economic good, this belief is wrong. However, the ‘failure’ of QE programs to bring about high levels of what most people think of as inflation has generated a false sense of security.

The difference between money and every other economic good is that money is on one side of almost every economic transaction. Consequently, there is no single number that can accurately represent the price (purchasing power) of money, meaning that even the most honest and rigorous attempt to calculate the “general price level” will fail. This doesn’t imply that changes in the supply of money have no effect on money purchasing power, but it does imply that the effects of changes in the money supply can’t be explained or understood via a simple equation.

Further to the above, the Quantity Theory of Money (QTM) is not a valid theory. Ludwig von Mises thoroughly debunked this theory a hundred years ago and I summarised its basic flaws in a blog post two years ago. Unfortunately, QTM’s obvious inability to explain how the world works has strengthened the belief that an increase in the supply of money has no significant adverse effect on the price of money.

The relationship between an increase in the money supply and its economic effects is complicated by the fact that the effects will differ depending on how and where the new money is added. Of particular relevance, the economic effects of a money-supply increase driven by commercial banks making loans to their customers will be very different from the economic effects of a money-supply increase driven by central banks monetising assets. In the former case the first receivers of the new money will be within the general public, for example, house buyers/sellers and the owners of businesses, whereas in the latter case the first receivers of the new money will be bond speculators (Primary Dealers in the US). Putting it another way, “Main Street” is the first receiver of the new money in the former case and “Wall Street” is the first receiver of the new money in the latter case. This alone goes a long way towards explaining why the QE programs of Q4-2008 onward had a much greater effect on financial asset prices than on the prices that get added together to form the Consumer Price Index (CPI).

Clearly, the QE programs implemented over the past 11 years had huge inflationary effects, just not the effects that many people expected.

A proper analysis of the effects of the QE programs has not been done by central bankers and the most influential economists. As a result, there is now the false sense of security mentioned above. It is now generally believed that substantially increasing the money supply does not lead to problematic “inflation”, which, in turn, lends credibility to monetary quackery such as MMT (Modern Monetary Theory).

Due to the combination of the false belief that large increases in the supply of money have only a minor effect on the purchasing power of money and the equally false belief that the economy would benefit from a bit more “price inflation”, it’s a good bet that central banks and governments will devise ways to inject a lot more money into the economy in reaction to future economic weakness. As is always so, the effects of this money creation will be determined by how and where the new money is added. If the money is added via another QE program then the main effects of the money-pumping again will be seen in the financial markets, at least initially, but if the central bank begins to monetise government debt directly* then the “inflationary” effects in the real economy could be dramatic.

The difference between the direct and the indirect central-bank monetising of government debt is largely psychological, but it is important nonetheless. When the central bank monetises government debt indirectly, that is, via intermediaries such as Primary Dealers, it is perceived to be conducting monetary policy (manipulating interest rates, that is). However, when the central bank monetises government debt directly it is perceived to be financing the government, thus eliminating any semblance of central bank independence and potentially setting in motion a large decline in monetary confidence.

According to the book Monetary Regimes and Inflation, ALL of the great inflations of the 20th Century were preceded by central bank financing of large government deficits. Furthermore, in every case when the government deficit exceeded 40% of expenditure and the central bank was monetising the bulk of the deficit, a period of high inflation was the result. In some cases hyperinflation was the result.

In summary, growth in the money supply matters, but not in the simplistic way suggested by the Quantity Theory of Money. There’s a good chance that this fact will be rediscovered within the next few years, especially if legislative changes enable/force the Fed to monetise government debt directly.

*In the US this would entail the Fed paying for government debt securities by depositing newly-created dollars into the government’s account at the Fed. The government would then spend the new money. Currently the Fed buys government debt securities from Primary Dealers (PDs), which means that the newly-created dollars are deposited into the bank accounts of the PDs.

One of the past month’s interesting stock-market developments was the strength of the banking sector in both nominal terms and relative to the broad market. The strength in nominal dollar terms is illustrated by the top section of the following weekly chart, which shows that the US Bank Index (BKX) is threatening to break out to the upside. The strength relative to the broad market is illustrated by the bottom section of the chart, which reveals a sharp rebound in the BKX/SPX ratio since the beginning of September.

Bank stocks tend to perform relatively well when long-term interest rates are rising in both absolute terms and relative to short-term interest rates. This explains why the banking sector outperformed during September and also why bank stocks generally have been major laggards since early last year.

Valuations in the banking sector are depressed at the moment, as evidenced by relatively low P/Es and the fact that the BKX/SPX ratio is not far from a 25-year low. This opens up the possibility that we will get a few quarters of persistent outperformance by bank stocks after long-term interest rates make a sustained turn to the upside.

On a related matter, the relative performance of the banking sector (as indicated by the BKX/SPX ratio) is an input to my “true fundamentals” models for both the US stock market and the gold market. However, when the input is bullish for one of these markets it is bearish for the other. In particular, relative weakness in the banking sector is considered to be bullish for gold and bearish for general equities.

Until recently the BKX/SPX input was bullish in my gold model and bearish in my equity model, but there was enough relative strength in the banking sector during the first half of September to flip the BKX/SPX input from gold-bullish to equity-bullish. As a consequence, during the second week of September there was a shift from bullish to bearish in my Gold True Fundamentals Model (GTFM). This shift is illustrated on the following weekly chart by the blue line’s recent dip below 50.

The upshot is that the fundamental backdrop, which was supportive for gold from the beginning of this year through to early-September, is now slightly gold-bearish. My guess is that it will return to gold-bullish territory within the next two months, but in situations like this it is better to base decisions on real-time information than on what might happen in the future.