Future “inflation” and the Fed’s madness

Prior to 2002 the Fed would tighten monetary policy in reaction to outward signs of rising “price inflation” and loosen monetary policy in reaction to outward signs of falling “price inflation”, but beginning in 2002 the Fed became far more biased towards loose monetary policy. This bias is now so great that it seems as if the Fed has become permanently loose.

The following chart comparing the Fed Funds Rate (FFR) target set by the Fed with the Future Inflation Gauge (FIG) clearly illustrates the change in the Fed’s tactics over the past two decades. The Future Inflation Gauge is calculated monthly by the Economic Cycle Research Institute (ECRI) and should really be called the Future CPI Gauge, because it is designed to lead the CPI by about 11 months.

The chart shows that prior to 2002 the FFR tended to follow the FIG. After the FIG warned of rising “price pressures” the Fed would start hiking the FFR, and after the FIG started signaling reduced upward pressure on the CPI the Fed would start cutting the FFR. (Note: My chart begins in 1994, but the relationship between the FFR and the FIG that I just described goes back much further.) During 2002-2004, however, the Fed not only didn’t hike its targeted interest rate in response to a sharp increase in the FIG, it continued to cut the FFR.

The Fed’s decision to maintain an ultra-loose stance during 2002-2004 was the fuel for the real estate investment bubble and set the stage for the collapse of 2007-2009.

There was a lesson to be learned from what happened during 2002-2007, but the Fed clearly learned the wrong lesson. The lesson that should have been learned was: Don’t provide monetary fuel for bubble activities, because the eventual economic fallout will be devastating. Unfortunately, the lesson that was actually learned by the Fed was: An economic bust can be avoided forever by keeping monetary policy loose forever. The result is that the divergence between the FFR and the FIG that arose during the first half of the last decade is nothing compared to the divergence that is now in progress. The FIG has been working its way higher since early-2009 and just hit a 5-year high, while the Fed’s ZIRP (Zero Interest Rate Policy) remains firmly entrenched.

Zooming in on the shorter-term fluctuations, last year’s small decline in the FIG suggested that there wouldn’t be a significant increase in the CPI’s growth rate until at least the final few months of this year, while the rise in the FIG that began late last year suggests that “price inflation” will start to become apparent in the CPI during the final quarter of this year and could be perceived as a serious problem during the first half of next year. This probably means that by early next year the T-Bond bears will start to look correct and the Fed will start to feel irresistible pressure to begin a rate-hiking program. Unfortunately, the US economy is now so rife with ‘bubble activities’ (businesses, projects, investments and speculations that are only viable due to artificially low interest rates and a rapid stream of new money) that a severe downturn is likely to follow an attempt by the Fed to ‘normalise’ its monetary policy.

By ignoring investment bubbles and erring far more in favour of “inflation” than it has ever done in the past, the Fed has set the stage for the mother-of-all economic busts. If the bust doesn’t begin earlier it is likely to begin soon after the Fed starts to raise its targeted interest rate.

[This blog post is a brief excerpt from a recent commentary published at speculative-investor.com]

Why has the junior end of the gold mining world performed so poorly over the past two years. In particular, why has it performed so poorly over the past 12 months in parallel with a relatively strong gold market?

Understanding why begins with understanding that in the absence of a mining operation that can be used to PROFITABLY extract it from the ground, gold in the ground has option value only. The option could be valued by the market at almost zero or a lot depending on many factors, the most important variable being the public’s desire to speculate. Furthermore, a gold mining operation that generates losses year after year also has option value only, with the public’s desire to speculate again being the most important determinant of the option’s market value.

In other words, with the relatively illiquid stocks it comes down to the general public’s desire to speculate.

Hedge funds usually will focus on gold mining ETFs or the larger-cap gold stocks because they need the liquidity. Wealthy professional investors such as Eric Sprott typically will take positions via private placements with the aim of eventually exiting via a liquidity event such as a takeover. It’s the general public that determines performance at the bottom of the food chain and over the past two years the public has become progressively less interested in speculating. Hence, the market values of stocks with option value only have become a lot cheaper.

Although during the course of this year we have suggested directing most new buying in the gold sector towards profitable producers, we are still interested in gold stocks that have option value only. These are the stocks that will generate by far the largest returns after the general public starts getting interested in the sector. However, sparking that interest probably will require a minimum of all-time highs in the US$ gold price and gold mining indices such as the HUI breaking above their H1-2023 highs, which probably won’t happen until the first half of next year. In fact, based on the historical record, sparking the general public’s interest in speculative gold mining stocks could require the broad stock market to begin discounting the combination of a recovery from recession and much easier monetary conditions, which possibly won’t happen until the first half of 2025.

Until then, most (not all) new buying in the gold sector should be directed towards profitable producers, that is, towards the stocks of real businesses. But, only when they are oversold or consolidating. Don’t get excited and buy them after they have just gone up a lot.

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

This is a follow-up to our 25th April piece titled “Inconvenient Facts” in which we summarised some of the issues that are ignored or brushed over by many proponents of a fast transition to a world dominated by renewable energy sources. The follow-up was prompted by a recent RealVision.com interview of Wil VanLoh, the CEO of Quantum Energy Partners, by Kyle Bass. The charts displayed below were taken from this interview.

To summarise the summary included in our earlier piece, it takes a lot of energy and minerals to build renewable energy systems and it takes years for a renewable energy system to ‘pay back’ the energy that was used to build it. Consequently, achieving the energy transition goals set by many governments will require increasing production of fossil fuels for at least the next ten years, which, in turn, will require substantially increased investment in fossil fuel production and distribution (pipelines, terminals, storage facilities and ships). In addition, achieving today’s energy transition goals will necessitate substantially increased production of certain minerals, meaning that it will require more mining.

With regard to the need for more mining to bring about the Sustainable Energy Transition (SET), the top section of the following chart compares the quantities of minerals required to build a conventional car with the quantities required to build an electric car. The bottom section of the same chart does a similar comparison of fossil-fuel (natural gas and coal) power generation and renewable (solar, on-shore wind and off-shore wind) power generation.

The next chart illustrates the increase in the production of several minerals that will have to happen by 2030 to achieve the current energy transition goals. Of particular interest to us, it shows that over the next eight years copper and zinc production will have to double, manganese production will have to increase by 5-times, nickel production will have to increase by 11-times and lithium production will have to increase by 18-times.

On a related matter, mining is an energy-intensive process. Moreover, the bulk of the increased mining required to meet the current SET goals will occur in places where the only economically-viable sources of energy will be fossil-fuelled power stations or local diesel-fuelled generation. This means that the increase in mining required for the energy transition will, itself, require increased production of coal, natural gas and diesel.

Soaring prices of oil, natural gas, coal and oil-based products (gasoline and diesel) have focused the attention of senior Western politicians on the urgent need for more oil and natural gas production. However, today’s supply shortages are due to a decade of under-investment in hydrocarbon production, which, in turn, is a) the result of political and social pressure NOT to invest in such production, b) a problem that even in a best-case scenario will take many years to resolve, and c) a problem that will be exacerbated by chastising oil companies and threatening government intervention to cap prices.

If it were possible to do so, ‘greedy’ oil and oil-refining companies would be very happy to flip a switch and increase production to take advantage of current high prices. The reality is that it isn’t possible and that increasing production to a meaningful extent will require large, long-term investments. But why should these companies take the risks associated with major investments to boost long-term supply when they continue to be pressured by both governments and their own shareholders to prioritise reduced carbon emissions above all other considerations and when there is enormous uncertainty regarding future government energy policy?

A lot of widely held beliefs associated with the financial markets and the economy are in conflict with the historical record and/or logic. One that I have addressed many times in the past (most recently HERE) is the belief that gold tends to be relatively strong when inflation expectations are rising.

Rising inflation expectations eventually could transform into a collapse in monetary/economic confidence, at which point gold would exhibit extreme relative strength. However, the run-of-the-mill increases in inflation expectations that occurred over the past few decades generally led to weakness in gold relative to the basket of commodities represented by the S&P Spot Commodity Index (GNX).

Here’s an update of the chart I have presented in previous blog posts that illustrates the relationship mentioned above. The chart shows a strong positive correlation over the past four years between the GNX/gold ratio and RINF, an ETF designed to move in the same direction as the expected CPI. That is, the chart shows that a broad basket of commodities tended to outperform gold during periods when inflation expectations were rising and underperform gold during periods when inflation expectations were falling.

As an aside, related to the above chart is the following chart comparing the commodity/gold (GNX/gold) ratio with the yield on the 10-year Treasury Note (TNX). Given the positive correlation between the commodity/gold ratio and inflation expectations, it isn’t surprising that there is a positive correlation between the commodity/gold ratio and the 10-year interest rate.

This year, inflation expectations bottomed in March and then trended higher. That’s the main reason why, in TSI commentaries over the past seven months and especially over the past two months, I have written that it was appropriate to favour industrial commodities over gold.

I currently expect the rising inflation expectations trend to continue for another 2-3 quarters. This means that I expect continued outperformance by industrial commodities for another 2-3 quarters, of course with corrections along the way. A correction (a period of relative strength in the gold price) actually could begin soon, partly because the gold price is now stretched to the downside while the prices of commodities such as copper, zinc, oil and iron-ore are stretched to the upside.

[Below is an excerpt from a TSI commentary published about two weeks ago. This discussion is being reproduced at the blog because it updates an opinion that was outlined at the blog way back in 2015-2016.]

Goldmoney (XAU.TO) originally was called BitGold and first began trading on the stock market in 2015. We wrote about the company four times at the TSI Blog during 2015-2016 (HERE, HERE, HERE, and HERE). The general theme of these writeups was: The company has a great product, but the stock is wildly overpriced.

Here’s how we summed up the Goldmoney business in the last of the above-linked blog posts:

“From the perspective of a Goldmoney user, the business is great. Customers can store gold, use gold as a medium of exchange and even take delivery of physical gold in manageable quantities, all at a low (or no) cost. From the perspective of a Goldmoney shareholder, however, the business is not so great. Of particular significance, unlike a mutual fund that charges a fee based on AUM (Assets Under Management), Goldmoney charges nothing to store its customers’ assets (gold bullion). This means that the larger the amount of Goldmoney’s AUM, the greater the net cost to the owners of the business (Goldmoney’s shareholders).

It’s important that under the current fee structure, Goldmoney will generally lose money on customers who use the service primarily for store-of-value purposes. This is where PayPal has a big advantage over Goldmoney. Nobody views their PayPal account as a long-term store of value. Instead, they view it as short-term parking for money to be spent, and when the money is spent PayPal usually gets a commission. This results in PayPal being very profitable, with earnings of US$1.2B (US$1.00/share) in 2015. Many of Goldmoney’s customers, however, view the service as a convenient way to store their physical gold. They don’t want to spend their gold, they want to save it.

Based on what I’ve seen to date I continue to believe that Goldmoney offers a great product, but is operating an inherently low-margin business deserving of a low valuation. Use the service, but don’t buy the stock.”

Since 2016 the company has grown a lot, mainly by acquiring similar or related businesses. Most importantly, it has modified its business model and now generates revenue/earnings from precious metals storage and lending. The fee structure is outlined HERE.

Over the same period the share price has trended down from highs of C$8.00 in 2015 and 2017 to a current level of C$2.18. Incredibly, the fundamental value of an XAU share is higher today with the stock trading near C$2 than it was in 2015-2017 when speculative fervour briefly caused the shares to trade as high as C$8.

Goldmoney Inc. now owns/operates two precious metals businesses called Goldmoney.com and Schiff Gold. Revenue for these businesses is earned as a weight of precious metal each time a client buys, sells, exchanges, takes delivery or stores precious metals through one of these businesses. Also, Goldmoney owns 37% of a jewellery manufacturer called Mene Inc. (MENE.V) and earns interest (in precious metals form) through the lending of precious metals to Mene. Lastly, Goldmoney owns/operates a company called Lend & Borrow Trust (LBT) that generates income by making fiat currency loans that are fully secured by precious metals.

The bulk of XAU’s earnings is in the form of precious metals that accumulate on the balance sheet. Furthermore, balance sheet assets not allocated to current working capital, investments and intangible assets are used to purchase and hold physical precious metals, the idea being that XAU’s holdings of gold, silver, platinum and palladium ounces will grow steadily over time.

With a Goldmoney account it is easy to buy and sell physical precious metals (PMs) at very competitive bid-ask spreads, with the PMs stored in secure vaults on an allocated basis (each client has ownership of specific pieces of metal). Also, it is possible to take delivery of your metal. Therefore, it could make sense to build up direct ownership of PMs via a Goldmoney.com account.

Alternatively, as long as the shares are purchased when they are trading near book value (BV), owning XAU shares is a reasonable way to build up indirect ownership of PMs. Owning the shares has the added advantage that if the company is well-managed then the amount of physical metal per share will increase over time.

The current BV is C$2.28/share including goodwill and C$1.79/share excluding goodwill. We think the latter number is the more relevant and therefore that the shares would be very attractive for long-term investment purposes at around C$1.80. However, the current premium to the C$1.79/share BV is not excessive, so if you are interested in XAU then it could make sense to take an initial position near the current market price of C$2.18.

[In a blog post last October I mentioned that a recent divergence between the gold/commodity ratio and the T-Bond price had bullish implications for the T-Bond. A strong rebound in the T-Bond soon got underway. Another divergence between the gold/commodity ratio and the T-Bond price has since developed, this time with bearish implications for the T-Bond. A discussion of the most recent divergence was included in a TSI commentary published on 28th March and is reprinted below.]

The gold/commodity (g/c) ratio and the T-Bond price tend to move in the same direction. As previously explained, this tendency is associated with what Keynesian economists call a paradox (“Gibson’s Paradox”) and Austrian economists call a natural and perfectly understandable consequence of the relationship between time preference and prices. The reason for revisiting the gold-bond relationship today is that a significant divergence developed over the past three months and such divergences are usually important.

The following chart illustrates our point that the gold/commodity ratio (the US$ gold price divided by the GSCI Spot Commodity Index) and the T-Bond price move in the same direction most of the time. It also shows that over the past three months the two quantities have diverged, with the g/c ratio trending downward while the T-Bond price extended its upward trend and moved to a marginal new 12-month high.

Given that the relationship between the g/c ratio and the T-Bond has a solid fundamental basis, that is, given that it’s not a case of random correlation, it should continue to apply. Therefore, we expect that the divergence will close over the months ahead — via either a rise in the g/c ratio to above its December-2018 high or a decline in the T-Bond price to well below its February-2019 low.

The divergence probably will close via a decline in the T-Bond price, because if there is a leader in this relationship it is the g/c ratio. For example, in each of the three biggest divergences of the past five years (the areas inside the blue boxes drawn on the above chart), the g/c ratio reversed course months in advance of the T-Bond. The g/c ratio also led the T-Bond by 2-3 months at the Q3-2017 top and by a couple of weeks at the Q4-2018 bottom. In other words, the recent performance of the g/c ratio is a reason to be intermediate-term bearish on the T-Bond.

One realistic possibility is that the T-Bond is now topping similarly to how it bottomed between December-2016 and March-2017. Back then, both the g/c ratio and the T-Bond turned up at around the same time (in late December of 2016), but whereas the g/c ratio trended upward throughout the first quarter of 2017 the T-Bond made a marginal new low in March before commencing an upward trend of its own. This time around the g/c ratio and the T-Bond turned down at around the same time (in late December of 2018), but whereas the g/c ratio has continued along a downward path the T-Bond has risen to a marginal new multi-month high.

Governments and central banks lost interest in the gold price decades ago, but stories about how governments are supposedly controlling the gold price never lose their appeal. One of the latest stories is that since the inclusion of the Yuan in the IMF’s SDR (Standard Drawing Rights) basket in October-2016, the Chinese government has pegged the SDR-denominated gold price to 900 +/- a few percent. According to The Macro Tourist’s 25th July blog post, this story has been told by Jim Rickards. The Macro Tourist suggests a different story*, which involves the Chinese government (or someone else) having pegged the Yuan-denominated gold price. Both stories are based on gold’s narrow trading range relative to the currency in question over the past two years.

If we are going to play this game then I can tell an even better story. My story is that the Japanese government took control of the gold market in early-2014 and has since been keeping the Yen-denominated gold price at 137,000 +/- 5%. They lost control in early-2015 and again in early-2018, but in both cases they quickly brought the market back into line.

Here’s the chart that ‘proves’ my version of events:

The narrow sideways range of the Yen gold price over the past 4.5 years is due to the Yen being the major currency to which gold has been most strongly correlated. Here’s a chart that illustrates the strong positive correlation between Yen/US$ and gold/US$:

My story about the Japanese government pegging the gold price makes as much sense as the stories about the Chinese government pegging the gold price. That is, my story makes no sense.

It will be possible to find price data to substantiate almost any manipulation story. Also, with sufficient imagination there is no limit to the manipulation stories that can be concocted to explain any price action. For example, you can always look at a period of range-trading in the gold market and conclude that a government (the same organisation that makes a mess of everything else it tries to do) is adeptly managing the price. Alternatively, you can look for a more plausible explanation or perhaps just acknowledge that not all price action has a single, simple explanation.

Like all financial markets the gold market is, of course, manipulated, but even if there were a desire to do so (there isn’t) it would not be possible under today’s monetary system for any government to directly control the gold price over a period of years or alter major trends in the gold price.

*In general the Macro Tourist blog provides level-headed commentary on the financial markets and doesn’t plunge into the murky world of gold-manipulation story-telling. Even in this case I think the main point of the post is to show that gold is stretched to the downside and may be good for a short-term trade, but some people will take the post as more evidence that the gold market is dominated by nefarious forces.

A 23rd June post at the TSI Blog described the model (the Gold True Fundamentals Model – GTFM) that I developed to indicate the extent to which the fundamental backdrop is bullish for gold. The GTFM is an attempt to determine a single number that incorporates the most important fundamental drivers of the gold price, where I define “fundamental driver” as something that happens in the economy or the financial markets that causes a significant change in the desire/urgency to own gold in some form. Keith Weiner subsequently posted an article objecting to some of my “fundamental drivers”, which would be fine except that his article contains several misunderstandings of these price drivers and/or how I am using them. The purpose of this post is to address these misunderstandings and provide a little more information on the GTFM’s components.

1. The ‘Real’ Interest Rate

Keith states: “The Real Interest Rate is the Nominal Interest Rate – inflation.” No, that’s not what the real interest rate is, although many people wrongly calculate it that way.

Keith and I agree that it is not possible to calculate the economy-wide change in money purchasing-power (PP), but even if it were possible to come up with a single number that represented prior “inflation” the real interest rate would not be the nominal interest rate minus this number. The reason, to explain using an example, is that the real return that will be obtained by someone who makes a 12-month investment today in an interest-bearing security will have nothing to do with the change in the PP of money over the preceding 12 months. Instead, the real return that will be obtained by this person will be determined by the change in money PP over the ensuing 12 months.

Now, we can obviously never know in advance what the real return on any interest-bearing security or deposit will be, but since the advent of Treasury Inflation-Protected Securities (TIPS) in 2003 it has been possible to roughly determine the real return on Treasury debt expected by the average bond trader. The TIPS yield, which is based on the EXPECTED rate of currency depreciation, is my ‘real’ interest rate proxy.

If there had been a TIPS market in the 1970s then it would probably be apparent that the large gains made by the gold price during that decade were related to a low/falling real interest rate, where the real interest rate is defined as the nominal interest rate minus the expected rate of currency depreciation. In any case, there has definitely been an inverse correlation between the TIPS yield (10-year or 5-year) and the gold price over the past 10 years. Furthermore, the correlation has strengthened over the past 2 years.

By the way, it’s the DIRECTION, not the value, of the TIPS yield that matters to gold and that is taken into account by the GTFM.

The inverse relationship between the TIPS yield and the gold price is far from perfect, the reason being that there are times when other price drivers are more influential. That’s why the ‘real interest rate’ has only a one-seventh weighting in the GTFM.

2. The Yield Curve

There has never been a strong and consistent short-term correlation between the gold price and the yield curve, but near major turning points the yield curve tends to be the dominant driver.

In broad terms, the boom phase of the central-bank-promoted boom-bust cycle is generally associated with a flattening yield curve and the bust phase is generally associated with a steepening yield curve. Gold generally performs better during the bust phase, when the curve is steepening. Somewhat counterintuitively, banks tend to do best during the long periods of yield-curve flattening. This can be demonstrated empirically and makes sense if you understand how the central-bank-promoted boom-bust cycle works.

A major flattening trend in the US yield curve got underway during the second half of 2011 and continues to this day. This flattening trend is associated with a boom, which, in turn, has temporarily helped the banks and reduced the desire to own gold.

3. Credit Spreads

The trend in credit spreads is one of the best measures of the overall trend in economic confidence, with widening spreads (yields on lower-quality bonds rising relative to yields on higher-quality bonds) being indicative of declining economic confidence. Gold tends to do relatively well during periods when economic confidence is on the decline, that is, during periods when credit spreads are widening. I have demonstrated this in the past using charts.

4. The Relative Strength of the Banking Sector

Keith writes: “We haven’t plotted it, but we assume bank stocks will outperform the broader stock market when the yield curve is steeping by way of falling Fed Funds rate. This is when the banks’ net interest margin is rising, and they are getting capital gains on their bond portfolio too. At the same time, credit spreads are narrowing, so the banks are getting capital gains on their junk bonds.”

No, that’s not how it works. Refer to my yield curve comments above for a very brief explanation.

The banking sector will often fare poorly during major yield-curve steepening trends because a banking crisis is often a primary cause of the steepening trend. In any case, this indicator is based on the concept that the investment demand for gold will be boosted by declining confidence in the banking system and reduced by rising confidence in the banking system.

5. The US Dollar’s Exchange Rate

More often than not, the US$ gold price trends in the opposite direction to the Dollar Index. However, there are times when a crisis outside the US causes both a rise in the US$ on the FX market and a large rise in the US$ gold price. The fact that the inverse correlation between the gold price and the Dollar Index can break down in a big way at times is why the US dollar’s performance on the FX market only has a one-seventh weighting in the GTFM. To put it another way, if the gold price always moved in the opposite direction to the Dollar Index then there would be no reason for gold traders to consider anything except the Dollar Index.

6. The General Trend in Commodity Prices

I have included the general trend in commodity prices as indicated by the S&P GSCI Commodity Index (GNX) in the GTFM for the practical reason that there are times when it tips the balance. That is, there are times when a strong upward trend in commodity prices enables the US$ gold price to rise despite an otherwise slightly-bearish (for gold) fundamental backdrop and there are times when a strong downward trend in commodity prices causes the US$ gold price to fall despite an otherwise slightly-bullish fundamental backdrop.

7. The Bond/Dollar Ratio

There are fundamental reasons for the existence of a positive correlation between the bond/dollar ratio (the T-Bond price divided by the Dollar Index) and the US$ gold price, but I currently don’t have the time or the inclination to go into these reasons. Instead, for the sake of brevity I present the following chart-based comparison of the gold price and the bond-dollar ratio. The positive correlation is obvious and is evident over much longer periods than the 3-year period covered by this chart.

I hope the above goes at least part of the way towards explaining the components of my gold model.

Two months ago I posted a short article in which I discussed an example of how the change in an economic statistic was greatly exaggerated — in order to paint a misleading picture — by showing the percentage change of a percentage. I’ll now discuss another example of using the same trick to make the change in an economic number seem far more dramatic than was actually the case.

Before getting to the specific example, the general point is that when analysing economic data — or any other data for that matter — it won’t make sense to consider the percentage of a percentage unless it’s the second derivative that you are primarily interested in. When you take the percentage change of a percentage you cause a change in the underlying number from 0.5 to 1.0 to become the same as a change in the underlying number from 5 to 10 or 100 to 200, but in the real world the change in an economic number from 5 to 10 will usually have vastly different implications to the change in the same number from 0.5 to 1.0. For example, there is a huge difference between a change in the rate of GDP growth from 0.5% to 1.0% and a change in the rate of GDP growth from 5% to 10%, but both constitute a 100% increase in the rate of growth.

On a related matter, it can also be problematic to look at percentage changes of economic numbers when the numbers are fluctuating near zero. This is because a move from one miniscule value to another can be large in percentage terms. For example, a move from 0.01 to 0.03 is a 200% increase.

The specific example that prompted this post appeared in John Mauldin’s recent article titled “Negative Rates Nail Savers“. The gist of the Mauldin piece is completely correct, but during the course of the long article some mistakes were made. I’m zooming-in on the mistake contained in the following excerpt:

“Here is a long-term chart of the federal funds rate, the Fed’s main policy tool:

The gray vertical bars represent recessions. You can see how the Fed has historically dropped rates in response to recessions and then tightened again when those recessions ended. I red-circled the particularly drastic loosening and retightening under Paul Volcker in the early 1980s and Ben Bernanke’s cuts to near-zero in 2008.

To this day, the Volcker rate hikes are legendary. No Fed chair has ever done anything like that, before or since. You hear it all the time. Problem: it’s not true.

Here is the same chart again, this time with a log scale on the vertical axis. This adjusts the rate changes to be proportionate with percentage rises and falls. The percentage change between 5% and 10% is the same as between 10% and 20%, since both represent a doubling of the lower number.

Looking at it this way, the Volcker hikes are tame, almost unnoticeable. Meanwhile the Bernanke cuts dwarf all other interest rate changes since 1955. Nothing else is even close. Bernanke’s rate cuts were far, far more aggressive than Volcker’s rate hikes.”

The fact that looking at it this way “the Volcker hikes are tame, almost unnoticeable” should have told Mr. Mauldin that it was the wrong way to look at it. Moreover, looking at it Mr. Mauldin’s preferred way, even the tiny up-tick in the Fed Funds Rate last December makes Volcker’s hikes seem tame. After all, when the Fed nudged the target Fed Funds Rate up from 0.125% to 0.375% last December it could be described as a 200% rate increase (since 0.375 is three-times 0.125). This means that by taking the percentage change of a percentage, or in this case by charting percentages using a log scale, it can be shown that last December’s rate hike was the most aggressive monetary tightening in the Fed’s history!

I suspect that Mr. Mauldin’s mistake was innocent, but a sure way to reduce the credibility of an otherwise good argument is to use flawed statistical methods to support it.

During the week since I first wrote about BitGold (XAU.V) the stock price has been on a wild ride. It went from C$4.14 up to C$8.00, down to C$4.50, up to C$6.50, and ended the 25th May trading session at C$5.60. At C$5.60/share and with a new (post-acquisition) share count of around 50M, the company has a market cap of roughly C$280M (US$230M). The product appears to be excellent from the perspective of customers, but is the business really worth US$230M?

Let me ask the above question in a different way. With its current fee structure and likely user base it’s possible that BitGold will never be consistently profitable and cash-flow positive. If a business does not have a good chance of ever being consistently profitable or cash-flow positive, what’s it worth?

As a standalone enterprise it is worth very little, especially considering that the company in question could run into regulatory problems after it puts its debit card into operation (this is the point at which governments will start taking a keener interest). However, it could be worth a lot to another company if the money-losing business is complementary to the acquirer’s existing business. For example, companies such as Google and Facebook have paid huge sums (billions of dollars) for businesses that would likely never be consistently profitable as standalone enterprises. They’ve done so because of the value that these businesses would potentially add to the existing Google and Facebook operations.

In any case, I doubt that anyone who has bought BitGold shares at prices above C$4 has done a realistic calculation of the business’s value as either a standalone enterprise or as an add-on to a larger financial services company. Actually, very few of the buyers would have done any calculation of value whatsoever. Instead, they would have bought because they like the idea of BitGold, oblivious to the fact that a good business can be a bad investment at the wrong price, or because they think that someone else will be dumb enough to pay an even higher price in the future.

Moving on, I’m impressed by the company’s senior managers. They did a terrific job of setting up an electronic gold-trading/payment platform, because the system, although simple from a customer’s perspective, is complex. In addition, they have done a fine job to date of whipping up enthusiasm for the stock and they demonstrated financial acumen by using the over-valued shares to make a big acquisition.

The big acquisition I’m referring to is the purchase of GoldMoney.com (GM), a company founded by James Turk, for about C$50M in XAU shares. GM was originally designed to do what BitGold is now planning to do, although it has since turned into a precious-metals dealing and storage service (it provides a cost-effective way for people to buy, hold and sell gold and other PMs without the hassle of taking delivery).

The first press release announcing the acquisition of GM was issued prior to the start of North American trading last Friday and was very misleading. Almost no financial details of the GM business were provided and the information that was provided created a false impression. Canada’s stock-market regulators obviously picked up on this, as the company’s plan to have its shares re-open for trading last Friday morning (the stock had been halted pending the news) had to be abandoned while it put together a new press release containing more details of what it was buying. This second attempt also appears to have been deemed unacceptable by the regulators, however, so the stock remained halted and a third press release announcing the GM acquisition was put out on Monday morning. The third time was the charm and the stock resumed trading around mid-day on Monday 25th May.

The financial details provided in the final press release revealed that GM’s business was shrinking at a rapid pace, that GM had generated only $5M of cash flow in its best year (2011), and that it was cash-flow negative over the past two years.

It’s unlikely that GM’s 135,000 current users will be significantly more profitable as part of BitGold than they were as part of GM.

I’m yet to read a proper valuation analysis (one that uses realistic assumptions) that demonstrates why BitGold deserves a multi-hundred-million-dollar market cap. Actually, I’m yet to read any proper valuation analysis from the bulls. According to the bullish articles I’ve read, you should simply buy the stock because the product is a great idea and the company’s founder is very smart. It’s as if there is no limit to what you should pay for an investment as long as there is a good story behind it. The bulls on the stock also point out that some big-name investors have taken significant BitGold positions. This is true, but the big-name investors generally paid C$0.90/share or less for their stakes. I could be wrong, but I doubt that they are interested in buying near the current price.

I don’t want it to seem as if I’m on some sort of crusade against BitGold. I very much want the business to succeed, because I like the product and want it to remain available. My only issue is with the stock’s valuation.

Even if the product makes great strides in popularity, with its current fee structure the underlying company will always be a low-margin business and therefore deserving of a low valuation. This, of course, doesn’t guarantee that the stock’s valuation won’t go a lot higher than its current elevated level, given the public’s proven ability to ignore valuation for long periods. There is also a chance that if BitGold can grow its customer base into the millions then it will be worth a lot to another electronic payment company such as PayPal or Mastercard, even if the BitGold business is a consistent money-loser. That’s one reason I definitely wouldn’t want to be short the stock and why, in terms of practical stock-market speculation (my primary source of income), I have no desire to get involved. Instead, I’ll continue to watch from the sidelines with detached amusement.

Summing up, my concern is that at some unknowable future time the “it’s a great product with smart management therefore the stock should be bought at any price” bubble of enthusiasm will collide with the “it will always be a low-margin business and therefore deserves a low valuation” brick wall of reality.

Yesterday I published a short piece dealing with the logical fallacies and self-contradictions in one of Ben Bernanke’s early blogging efforts. David Stockman has since published a more in-depth demolition of the same Bernanke post, titled “Central Banking Refuted In One Blog — Thanks Ben!“.

Stockman starts with Bernanke’s absurd assertion that because the Fed’s actions determine the money supply and the short-term interest rate, the Fed has no choice other than to set the short-term interest rate somewhere. He points out that as originally designed/envisaged, the Fed “had no target for the Federal funds rate; no remit to engage in open market buying and selling of securities; and, indeed, no authority to own or discount government bonds and bills at all.” Instead, “[the] entire purpose of the original Fed’s rediscounting tool was to augment liquidity in the banking system at market determined rates of interest. This modus operandi was the opposite of today’s monetary central planning model. Back then, the rediscount window at each of the twelve Reserve Banks had no remit except the humble business of examining collateral.”

According to Stockman: “…in 1913 there was no conceit that a relative handful of policy makers at the White House, or serving on Congressional fiscal committees or at a central bank could improve upon the work of millions of producers, consumers, workers, savers, investors, entrepreneurs and even speculators. Society’s economic output, living standards and permanent wealth were a function of what the efforts of its people added up to after the fact — not what the state exogenously and proactively targeted and pretended to deliver.”

Stockman’s point, in a nutshell, is that the machinations of today’s Fed represent one of the most egregious examples of mission creep in world history.

For anyone interested in economics and economic history there’s a lot of useful information in the Stockman post. For example, Stockman notes that during the 40 years prior to the 1913 birth of the Fed, “the US economy had grown at a 4% compound rate — the highest four-decade long growth rate before or since — without any net change in the price level; and despite the lack of a central bank and the presence of periodic but short-lived financial panics largely caused by the civil war-era national banking act.”

In fact, Bernanke’s short post and Stockman’s lengthy rebuttal make an interesting contrast. The former is gibberish, whereas the latter displays a good understanding of economic theory and history.

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

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

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

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

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

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

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