[Here is an excerpt from a commentary posted at TSI about a week ago]

In February of this year the year-over-year rate of growth in the US True Money Supply, a.k.a. the US monetary inflation rate, was only 2.4%. This was its lowest level since March of 2007 and not far from a multi-decade low. In March of this year, however, the monetary inflation rate almost doubled — to around 4.6%. Refer to the following chart for more detail. What caused the reversal and what effect will it have on the economy and the financial markets?

The Fed has been slowly removing money from the economy via its QT program, so March’s money-supply surge wasn’t caused by the central bank. The main cause also wasn’t the commercial banking industry, because although there has been an up-tick in the rate of bank credit expansion over the past month it is nowhere near enough to explain the increase in TMS.

We can’t be certain, but by a process of elimination we conclude that the sharp upward reversal in the US monetary inflation rate was due to money coming into the US from overseas. If so, the most likely driver would be the repatriation of corporate profits due to the tax changes approved near the end of last year.

In other words, it’s likely that March’s TMS surge was due more to the way that the banking system accounts for existing US dollars than an increase in the total supply of US dollars.

If the monetary inflation reversal has more to do with a change in the way existing US dollars are accounted for than a sudden large increase in the pace of new dollar creation, then the effects on the economy and the financial markets will be minimal. In any case, after the monetary inflation rate has moved high enough for long enough to set in motion an artificial boom, a drop to a relatively low inflation level will inevitably lead to a bust (an economic recession and a large decline in the stock market, often accompanied by a banking crisis). For example, the pronounced rebound in the TMS growth rate from Q4-2006 to Q3-2007 did not stop the recession, the equity bear market and the banking crisis of 2007-2009.

This means that as a result of the 2017 decline in the monetary inflation rate to near a 20-year low, the die has been cast.

The big unknown right now is the timing of the bust that will occur in response to last year’s precipitous decline in the monetary inflation rate. Will it get underway during the second half of this year or will it wait until next year?

In previous blog posts (e.g. HERE) I explained the limitations of sentiment as a market timing tool. Since the public is invariably wrong at price extremes, it certainly can be helpful to track the public’s sentiment and use it as a contrary indicator. However, whereas price extremes always coincide with sentiment extremes, sentiment extremes often don’t coincide with price extremes. This is especially the case during long-term bull markets, when sentiment is capable of staying very optimistic for years. It’s therefore best to think of a sentiment extreme as a necessary, but not a sufficient, condition for a price extreme.

With regard to US stock market sentiment there was an optimistic extreme in January of this year. This is evidenced by the TSI Index of Bullish Sentiment (TIBS) hitting a 20-year high at that time. Refer to the following weekly chart for details. Note that TIBS is a weighted average of four sentiment surveys (Investors Intelligence, Market Vane, Consensus-inc and American Association of Individual Investors), the 5-day moving average of the equity put/call ratio and the 5-day moving average of the VIX.

What is the probability that January’s optimistic extreme coincided with the top of the equity bull market?

The answer is: quite low. While sentiment was consistent with a major top and valuations, on average, were definitely high enough to usher in a major top, an end to the long-term upward trend was not signaled by several important indicators. For example, there would normally be a pronounced widening of credit spreads at or before a bull market top, but credit spreads remain near their narrowest levels of the past 10 years. For another example, there is likely to be a reversal in the yield curve from flattening to steepening at or prior to a bull market top, but at the end of last week the US yield curve was at its ‘flattest’ in more than 10 years. For a third example, there has been more strength in market internals over the past two months than there normally would be if we were dealing with the early stage of a bear market.

So, despite the rampant optimism evident in January-2018, the decline that followed the January peak probably will turn out to be a bull-market correction.

Among the list of stock selection and trading ideas maintained at the TSI web site there was, until the week before last, a Tesla (TSLA) put option position. The position was exited — and a large profit recorded — after the stock’s recent plunge from well above $300 to the $250s. However, this stock could present multiple opportunities over the coming 12 months to profit on the dark (bearish) side as it makes its way along the path to zero. TSLA could become the short that keeps on giving.

In fact, the fast rebound from the 2nd April low in the mid-$240s to the 9th April high of $309.50 may have already created the next such opportunity. The reason is that the rebound appears to have ended near the top of the former major support at $300-$310, the implication being that the stock has completed a successful test of its breakdown.

The company is clearly in trouble. It is hemorrhaging cash and running out of money, it is suffering production problems, it has possibly engaged in fraudulent accounting and is under investigation, and it will soon be faced with much greater competition from companies that are far more adept at vehicle manufacturing. And yet, it still sports an extremely high market valuation.

TSLA bears will have to remain on guard, though, because Elon “the carnival barker” Musk is still capable of whipping up enthusiasm.

[This blog post is an excerpt from a TSI commentary published on 27th March 2018]

The policies of the Trump Administration are being influenced by the view that international trade is a zero sum game, where whoever receives the most money is the winner at the expense of whoever receives the most goods. Under this line of thinking, which sometimes goes under the name “mercantilism”, policies are beneficial if they increase the amount of money coming into the country relative to the amount of money going out of the country. As discussed below, it’s the wrong way to look at the world.

Another way of framing the mercantilist position is that the winner is the one who ends up with the larger amount of the medium of exchange and the loser is the one who ends up with the larger amount of real wealth. For reasons we’ll get into in a moment there are actually no winners and losers, but if it were true that one side was getting the better deal then surely it would be the one that ended up with the most real wealth; especially these days, when the medium of exchange is created out of nothing by the banking system.

Also, it’s important to understand that countries don’t trade with each other. For example, the US doesn’t trade with China. What we mean is that a country is not an economic entity that buys and sells. Instead, individuals in one country trade with individuals in another country and in each transaction both sides believe that they are benefiting (otherwise the transaction wouldn’t happen). While it is technically possible to lump together all the transactions undertaken by the individuals in one region and arrive at the conclusion that ‘we’ have a trade deficit or ‘we’ have a trade surplus, in the real world there is no ‘we’ when it comes to trade.

Unfortunately, however, governments pay attention to the meaningless lumping-together of millions of individual transactions, and if the result happens to be what is commonly called a deficit then the government will often conclude that it should place obstacles in the way of many transactions. You may think that you are benefiting from a deal with a foreign seller, but according to the government you are creating a problem for the collective ‘we’ and must be hindered or stopped.

The Trump Administration is in the spotlight at the moment for having undertaken three sets of protectionist measures over just the past two months. There were the tariffs on imported washing machines and solar panels announced in January, the tariffs on imported steel and aluminium announced at the beginning of March and the as-yet-unspecified tariffs on $60B of Chinese imports announced last week. However, the US government does not have a monopoly on counter-productive mercantilism. Far from it! The same sort of ‘reasoning’ that has informed the trade-related missteps of the US government over the past two months is informing the actions of most governments around the world.

For example, other governments are threatening to impose their own tariffs in response to the US tariffs, which is something they would not do unless they wrongly believed that such restrictions could benefit their own economies. For another example, the large quantity of US$-denominated reserves collectively held by central banks around the world has almost nothing to do with the US$ being the official reserve currency and almost everything to do with exchange-rate management designed, using terribly flawed logic, to gain an international trade advantage. Refer to the May-2015 post at the TSI Blog for more colour on this issue.

There is nothing that any one government can do directly to change the wrongheaded protectionist ways of other governments. The best that any single government can do is to not become part of the problem. The ideal situation is that no side erects barriers to international trade, but the second-best situation for any one country is that its own government opts not to erect barriers. Just because some other government decides to impose economic sanctions on its own citizens doesn’t mean that your government is justified in doing the same.

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

The year-over-year rate of growth in the US True Money Supply (TMS) was around 11.5% in October of 2016 (the month before the US Presidential election) and is now only 2.4%, which is near a 20-year low. Refer to the following monthly chart for details. In terms of effects on the financial markets and the economy, up until recently the US monetary inflation slowdown was largely offset by continuing rapid monetary inflation elsewhere, most notably in Europe. However, the tightening of US monetary conditions has started to have noticeable effects and these effects should become more pronounced as the year progresses.

The tightening of monetary conditions eventually will expose the mal-investments of the last several years, which, in turn, will result in a severe recession, but the most obvious effect to date is the increase in interest rates across the entire curve. The upward acceleration in interest rates over the past six months has more than one driver, but it probably wouldn’t have happened if money had remained as plentiful as it was two years ago.

It would be a mistake to think that the tightening has been engineered by the Fed. The reality is that the Fed has done very little to date.

The Fed has made several 0.25% increases in its targeted interest rates, but the main effect of these rate hikes is to increase the amount of money the Fed pays to the commercial banks in the form of interest on reserves (IOR). It doesn’t matter how you spin it, injecting more money into banks ain’t monetary tightening!

The Fed’s actual efforts on the monetary loosening/tightening front over the past 5 years are encapsulated by the following weekly chart of Reserve Bank Credit (RBC). This chart shows that there was a rapid rise in RBC during 2013-2014 that ended with the completion of QE in October-2014. For the next three years RBC essentially flat-lined, which is what should be expected given that the Fed was neither quantitatively easing nor quantitatively tightening during this period. In October-2017 the Fed introduced its Quantitative Tightening (QT) program. To date, this program has resulted in only a small reduction in RBC, but the plan is for the pace of the QT to ramp up.

Strangely, the most senior members of the Fed appear to believe that their baby-step rate hikes constitute genuine tightening and that the contraction of the central bank’s balance sheet is neither here nor there. The reality is the opposite.

So, the Fed is not responsible for the large decline in the US monetary inflation rate and the resultant tightening of monetary conditions that has occurred to date.

The responsibility for the tightening actually lies with the commercial banks. As illustrated by the next chart, the year-over-year rate of growth in commercial bank credit was slightly above 8% at around the time of the Presidential election in late-2016 and is now about 3%.

We won’t be surprised if a steepening yield curve prompts commercial banks to collectively increase their pace of credit creation over the next two quarters, but with the Fed set to quicken the pace of its QT the US monetary inflation rate probably will remain low by the standards of the past two decades. At the same time, the ECB will be taking actions that reduce the monetary inflation rate in the euro-zone. This could lead to stock and bond market volatility during the second half of this year that dwarfs what we’ve witnessed over the past two months.

The major long-term driver of the gold price is confidence in the official money and in the institutions (governments, central banks and private banks) that create/promote/sponsor the official money. As far as long-term investors are concerned the gold story is therefore a simple one: gold will be in a bull market when confidence in the financial establishment (money, banks and government) is in a bear market and gold will be in a bear market when confidence in the financial establishment is in a bull market.

In real time it often doesn’t seem that simple, though, because on a weekly, monthly or even yearly basis a lot can happen to throw an investor off the scent. However, the risk of being thrown off the scent can be reduced by having an objective way of measuring the ebbs and flows in the confidence that drives, among other things, the performance of the gold market. That’s why I developed the Gold True Fundamentals Model (GTFM). The GTFM is determined mainly by confidence indicators such as credit spreads, the yield curve, the relative strength of the banking sector and inflation expectations, although it also takes into account the US dollar’s exchange rate and the general commodity-price trend.

An alternative to objective measurement is to rely on gut feel, but gut feel is notoriously unreliable in such matters because it is, by definition, influenced by personal biases. For example, it will be influenced by “projection bias”. This is the assumption that if you perceive things in a certain way, then most other people will perceive them in the same way. Projection bias plays a big part in a lot of gold market analysis. The market analyst will observe central bank or government actions that from his/her perspective are blatantly counter-productive, and go on to assume, often wrongly, that most market participants will view the actions in the same way.

Another alternative is to assume that gold’s fundamentals are always bullish and therefore that any large or lengthy price decline must be the result of a grand price-suppression scheme. Given its absurdity it’s amazing how popular this line of thinking has become in the gold market. Then again, it’s a line of thinking that has been aggressively promoted over the past two decades and has a certain emotional appeal.

Due to the effects of market sentiment the gold price occasionally will diverge from its ‘true fundamentals’ (as indicated by the GTFM) for up to a few months, but ALL substantial upward and downward trends in the gold price over the past 15 years have been consistent with the fundamental backdrop.

Does this invalidate the idea that manipulation happens in the gold market?

Of course not. Every experienced and knowledgeable trader/investor knows that all financial markets have always been subject to manipulation and always will be subject to manipulation. It does, however, invalidate the idea that there has been a successful long-term gold-price-suppression program.

The current situation (as at the end of last week) is that gold’s true fundamentals, as indicated by the GTFM, have been bearish for the past 10 weeks. Also, the true fundamentals have spent more time in bearish territory than bullish territory since the second half of last September. Refer to the following chart comparison of the GTFM and the US$ gold price for details.

Now, considering the fundamental backdrop it seems that the gold price has held up remarkably well over the past several months, but that conclusion only emerges if your sole measuring stick is the US$. When performance relative to the other senior currency (the euro) and the world’s most important equity index (the S&P500) are taken into account it becomes clear that the gold market has been weak. Here are the relevant charts.

The fundamental backdrop is continually shifting and potentially could turn gold-bullish within the next few weeks. It just isn’t bullish right now. Also, there could be a strong rally in the US$ gold price in the face of neutral-bearish fundamentals. If so, we would be dealing with a US$ bear market as opposed to a gold bull market.

In a gold bull market the ‘value’ of an ounce of gold rises relative to the major equity indices and both senior currencies. For this to happen the true fundamentals would have to be decisively bullish most of the time.

The rising interest-rate trend in the US isn’t new and isn’t related to the Fed’s so-called “policy normalisation” program. However, it has only just started to matter.

That the rising interest-rate trend isn’t new and isn’t related to the Fed’s rate-hiking efforts is clearly illustrated by the following chart. This chart shows that the US 2-year T-Note yield began trending upward in 2011 — more than 6 years ago and more than 4 years prior to the Fed’s first rate hike.

As we go further out in duration we find later beginnings to the rising-yield trend. This is evidenced by the following three charts, the first of which shows that the 5-year yield bottomed in mid-2012, the second of which shows that the 10-year yield double-bottomed in mid-2012 and mid-2016, and the third of which shows that the 30-year yield continued to make lower lows until mid-2016. But even in the case of the 30-year yield the rising trend is now more than 18 months old.

Given that US interest rates have been rising for more than 6 years at the short end and more than 18 months at the long end, why has the trend suddenly begun to draw a lot of attention in the mainstream press?

The answer is: because rising yields on credit instruments have begun to put downward pressure on equity prices. The stock market is capable of ignoring rising interest rates for long periods, as has been demonstrated by the market action of the past few years. However, if a rising interest-rate trend persists for long enough it transforms, as far as the stock market is concerned, from an irrelevance to the most important thing.

The way that interest rates gradually turned upward over several years despite the relentless downward pressure applied by the central bank suggests that we are dealing with the end of a very long-term decline. In other words, there’s a good chance that we are now in the early stages of a 1-2 decade (or longer) rising interest-rate trend. But how could that be, when debt levels are very high and the economy-wide savings rate is very low?

Under the current monetary regime, major upward trends in interest rates are not driven by the desire to consume more in the present (the desire to save less) or by rapidly-increasing demand for borrowed money to invest in productive enterprises. That, in essence, is a big part of the problem — interest-rate trends do not reflect what they should reflect. Instead, major upward trends in interest rates are driven primarily by rising inflation expectations, or, to put it more aptly, by declining confidence in money.

Of particular relevance, under the current monetary regime it is not only possible for a large, general increase in the desire to save to be accompanied by rising interest rates, it is highly probable that when a large rise in interest rates happens it will be accompanied by a general desire to save more. It’s just that the desire for greater savings won’t manifest itself as a greater desire to hold cash. It will, instead, manifest itself as a desire to hold more of something with near-cash-like liquidity that is not subject to arbitrary devaluation by central banks and governments. Gold is the most obvious example.

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

For a market analyst there is an irresistible temptation to seek out one or more historical parallels to the current situation. The idea is that clues about what’s going to happen in the future can be found by looking at what happened following similar price action in the past. Sometimes this method works, sometimes it doesn’t.

Assuming that the decline from the January-2018 peak is a short-term correction that will run its course before the end March (my assumption since the correction’s beginning in late-January), the recent price action probably is akin to what happened in February-March of 2007. In late-February of 2007 the SPX had been grinding its way upward in relentless fashion for many months. The VIX was near an all-time low and there was no sign in the price action that anything untoward was about to happen, even though some cracks had begun to appear in the mortgage-financing and real-estate bubbles. Then, out of the blue, there was a 5% plunge in the SPX. On the following daily chart this plunge is labeled “Warning shot 1″.

After the February-March ‘hiccup’ the SPX resumed its bull market. Both the stock market and the economy were believed to be in good shape, with the problems that had emerged in the realm of sub-prime mortgage lending generally considered to be contained to that relatively-unimportant part of the economy. No less of an authority than Ben Bernanke assured us that these problems were, indeed, contained.

The upward trend continued until mid-July, at which point another ‘out of the blue’ plunge began. This time the decline lasted 5 weeks and wiped 11% off the SPX. On the following daily chart it is labeled “Warning shot 2″.

The July-August decline was taken more seriously by almost everyone, including the Fed’s senior management. It was taken seriously enough, in fact, to prompt a reversal in the Fed’s monetary policy. The Fed entered rate-cutting mode.

During the weeks following the August-2007 low there was still widespread optimism. The overall economy was supposedly still strong, the Fed was being supportive and, as everyone knows, you should never fight the Fed.

The SPX went on to make a marginal new high in October-2007 and then commenced a bear market that over the ensuing 17 months would result in a loss of almost 60%.

The SPX was more stretched to the upside in January of 2018 than it was in February of 2007 and the more recent plunge was twice as big, but we could be dealing with Warning Shot 1. Also, this time around there may not be a second warning shot.

It is widely believed that silver leads gold during bull markets for these metals. I wonder how this belief first arose and persists to this day given that it is contrary to the historical record.

It is partially true that silver outperforms gold during precious-metals bull markets. In particular, it’s true that silver tends to achieve a greater percentage gain than gold from bull-market start to bull-market end. It’s also the case that silver tends to do better during the final year of a cyclical bull market and during the late stages of the intermediate-term rallies that happen within cyclical bull markets. However, the early stages of gold-silver bull markets are characterised by relative strength in gold.

Gold’s leadership in the early stages of bull markets is evidenced by the following long-term chart of the gold/silver ratio. The boxes labeled A, B and C on this chart indicate the first two years of the cyclical precious-metals bull markets of 1971-1974, 1976-1980 and 2001-2011, respectively. Clearly, gold handily outperformed silver during the first two years of each of the last three cyclical precious-metals bull markets that occurred within secular bull markets.

Now, in the same way that all poodles are dogs but not all dogs are poodles, the fact that gold tends to strengthen relative to silver in the early years of a precious-metals bull market doesn’t mean that substantial strength in gold relative to silver is indicative of a precious-metals bull market in its early years. For example, there was relentless strength in gold relative to silver from mid-1983 until early-1991 that took the gold/silver ratio as high as 100, but there was no precious-metals bull market during this period.

Between mid-1983 and early-1991 there was, however, a multi-year period when gold, silver, most other metals and mining stocks offered very profitable trading opportunities on the long side. I’m referring to 1985-1987. We are probably in a similar period today, with the next buying opportunity likely to arrive before the end of this quarter.

The amount of gold mined in a year is only about 1.5% of the total existing stock of gold, which is why changes in gold production have almost no effect on the gold price. It is also why changes in the cost of mining gold do not affect the gold price. In fact, cause and effect works the other way around — the change in the market price of gold determines, with a lag, the average cost of mining gold. To put it another way, the cost of mining gold follows the price of gold.

What happens is that as the gold price rises, mineral deposits or parts of deposits that were previously uneconomic become economic and start being mined. The mining of this lower-grade/higher-cost gold pushes up the average cost of production. And as the gold price falls, lower-grade/higher-cost gold is left in the ground and the average cost of production moves downward. Of course, there are substantial time-lags involved, because it takes years to bring a new mine into production and because mine plans won’t be changed in response to a price trend until the trend has been in progress for long enough to appear sustainable.

Adding to the tendency for the mining cost to follow the price is that after the price has been trending upward for a long period there will be less focus on cost control and more focus on growth, with the opposite being the case after the price has been trending downward for a long period.

Perhaps not surprisingly given that the Bitcoin system was designed to mimic gold in some respects, the relationship between the bitcoin mining cost and the bitcoin price is the same as the relationship between the cost of mining gold and the gold price. That is, the average cost of mining a bitcoin moves up and down with the price. That’s why, several years ago, it was profitable to mine bitcoins when the price was less than $1 and why the average cost of mining a bitcoin has since risen to around US$5,000.

One difference between gold and bitcoin is that the bitcoin mining industry can respond very quickly to changes in price. Whereas it probably will take at least a strong 3-year trend in the gold price to bring about a substantial change in the average cost of mining an ounce of gold, it takes almost no time to put a new bitcoin mining rig into operation and even less time to turn it off.

The way the Bitcoin distributed ledger system is designed, the computational gymnastics that have to be performed to add new blocks to the ‘chain’ and create new bitcoins scale up and down based on the total amount of computing power dedicated to the task. And the amount of computing power dedicated to the task will be dictated by the price. That is, the lower the price the smaller will be the total amount of resource (computing power and electricity) channeled into obtaining the reward of a new bitcoin, thus reducing the difficulty of performing the computations that verify transactions and the associated mining cost.

Therefore, if the price of a bitcoin falls from its current level of around $8,500 to only $100, mining bitcoins will remain a profitable business. It’s just that the quantity of resources being consumed/wasted by the mining process will be a small fraction of what it is today. Alternatively, if the price of a bitcoin skyrockets to $100,000 then the cost of mining bitcoin will also skyrocket, meaning that the quantity of resources being consumed by a process that adds nothing to the general standard of living will be vastly greater than it is today.

Returning to gold, a popular argument is that gold is an inefficient form of money due to the high cost of adding a new ounce to the existing stockpile. However, the relatively high cost of mining an ounce of gold is incurred regardless of whether or not gold is money; it is incurred because humans want to own gold and value it highly.

To further explain, well before gold was used as money, people liked to have it in their possession because of its physical characteristics: its look, feel, weight, malleability and extraordinary resistance to deterioration. In fact, it was the widespread desire to own gold that led to gold becoming money. And now that gold is no longer money (due to government command, not market preference), billions of people still desire it enough to cause the price and the mining cost to be relatively high. Allowing gold to be money again would therefore impose no additional cost.

Bitcoin is obviously different, in that its high price and associated high production cost are due solely to the possibility that it will, at some future time, be widely used as a medium of exchange. I think that the probability of this possibility is close to zero and therefore that the price of a bitcoin will eventually drop to near zero, but at the same time I think that the blockchain idea is brilliant.