Joseph M. Miller
(Part - II)
Chapter 4
When computers made their debut in the financial world in the sixties, it did not take too long for market participants to realize the value of this tool in analyzing markets and their behavior. The early work was done by financial people who were novices in computer use, which meant slow progress. As time passed, academic heavyweights knowledgeable in computer use came into the picture, accelerating the pace of advancement. These new people were mathematicians, rocket scientists, physicists, and computer specialists who were brought in to use their knowledge and talents from their academic disciplines in the pursuit of financial gain in the financial arena. The program was highly successful, and has been used more and more as time has passed.
Secrecy is the watchword surrounding the software programs developed by these new people, because their efforts are at the heart of how modern firms make money trading in megabyte money markets. The identity of these new computer superstars is closely guarded by their employers, so the competition can not easily lure them away. Needless to say, they earn huge salaries and bonuses.
The rapid rise of this type of analytical activity has shifted the focus of financial activity from investing long term to trading short term, since computers and good software programs made it possible to analyze large amounts of data in a short period of time. Prior to computers, by the time the calculations were done to analyze a situation, the factors would have changed and the reason and ability to act were past. The new information era with megabyte money has changed the traditional focus from investing for long periods of time, to trading minute shifts in value due to news or what have you, within markets or between markets. It is ironic that the wall street gurus preach investing for the long pull for the small investor. This innovation has changed all financial markets, including stocks, bonds, commodities, etc. In at least one very important instance, a large new industry was developed from the work of two academics who developed the Black-Scholes model for analyzing the value of options. Prior to their work, which had not been practical prior to the computer age, options were a small backwater area in the financial scheme of things. Now, as we all know, there are large exchanges devoted entirely to options trading as well as large sections of other exchanges that are devoted to options activity. New trading vehicles continue to be developed and used at a fast pace. Few have been as successful as the Black-Scholes effort.
In this new trading arena, traders no longer need or even want to know much about a firm's history, management, or product line. If it meets the criteria of their software program for such items as price action, volatility, and dividends for example, the stock will be bought and held until the software program says to sell. It is this type of trading that has separated the financial economy away from the real economy we discussed earlier and been a big cause, if not the chief cause for stocks to have soared in price way above any traditional yardstick of value. It is largely the cause of people saying we are in a new era, which we truly are. But it is a highly unstable and volatile era which caused Alan Greenspan to say in late 1996, that there was an element of "Irrational Exuberance" in the value of stock prices. It is important to note that powerful as Mr. Greenspan is in his position as Chairman of the Fed, his admonishment had only a fleeting impact on the market, before it continued its upward spiral. The infatuation of the people throughout the world with equity prices and ownership has taken on most of the aspects of a mania, every bit as virulent and dangerous as other manias such as the Tulip Mania in Holland, The Mississippi Bubble in France, The South Sea Bubble in England, and the Wall Street mania in 1929. An excellent book describing these manias is titled, "Extraordinary Popular Delusions and the Madness of Crowds". It is must reading for anyone wishing to understand the stock market in the late nineties.
During the nineties there has been much discussion about how the US economy could grow without inflation, when megabyte money creation was continuing at high speed. One of the main reasons for this phenomena is that the majority of the megabyte fiat money here and around the world, went into asset holdings, which has inflated their prices instead of real economy prices for goods. When this mania for asset prices subsides, for whatever reason, and the flow of megabyte fiat money flows back into the real economy for goods and services, consumer and producer price inflation could go up rapidly, as this ocean of fiat money chases the goods available.
At this point it is a good idea to get a feel of how much fiat money is out there flitting from one computer terminal to another around the world. When we try to do that, we find it is difficult or almost impossible to determine how much of this fiat money is available. Robert Brittan of Solomon Bros. told Joel Kurtzman, "there is no longer any way to measure how much money there is in the world. Nor is there any way to define it. The old terms of M1, M2 and M3 have become meaningless". This helps explain why the FED stopped placing so much emphasis on these numbers, and concentrates on interest rates. Who can say how high real economy prices may go when the almost limitless ocean of fiat money changes direction?
An obvious question arises from this discussion, just how much is each of the megabyte dollars worth? What determines their value? The key indicators of value seem to be interest rates and the confidence the world places in the issuer of the fiat currencies. What then does this in turn say about the price of a commodity, such as oil. I quote again from Joel Kurtzman.
According to Graciella Chilchinski, a professor of economics at Columbia University who has built a mathematical model of world oil demand, interest rates - not demand - now determine the price of oil and other commodities as well. Interest rates determine oil prices "because investors need a rate of return for their oil investments that is comparable to the rate of return they will get from simply putting their money in a financial investment of one kind or another", Chilchinski said. "If they get a better rate of return from lending money to companies(or governments, Ed. Note) than for exploring for oil, the oil will stay in the ground or its price will rise so it becomes an attractive investment as the ones in the financial sector".
By abandoning gold, Nixon enlarged the size of the finance economy by several orders of magnitude. He also moved the world onto a new standard: the interest rate standard. From that point of view all investment , finance and real, has a single benchmark: interest rates. And all investors have one simple goal: to earn more than the cost of money
In high interest rate countries-the United States, Canada, and Britain-companies have been forced to abandon long-term, lower-rate -of-return investments, such as manufacturing, in favor of finance to get sufficient returns. In low interest rate countries, such as Germany and Japan, manufacturing and the production of real goods still deliver a sufficient rate of return. And while low interest rate countries have factories that produce goods, high interest rate countries, such as the United States, are left only with debt
We can see that this process is alive and well throughout the world as this is being written. It is obvious from this excerpt from the WSJ on Dec. 5, 1997.
Australian Utilities Move Into Telecommunications, Finance By ANDREW TROUNSON AP-Dow Jones News Service SYDNEY—Australia's power utilities are taking the plunge into uncharted territory, promising to offer telecommunications and financial services in a bid to become large multi-utilities that can ride out the retail electricity market deregulation. Cut-throat price competition is already rampant as electricity retailers scramble to win market share ahead of 2000, when deregulation will be extended beyond large industrial power consumers to embrace even the smallest users. Analysts are tipping a major industry shake up as shrinking margins squeeze out the smaller players, while others diversify into gas and other add-on products, such as telecommunications and financial services. By Andrew Trounson
This obsession with yield has caused much havoc in world commerce and as the above article displays, is bringing great changes to the corporate landscape throughout the world. It begs an important question, when will the price of goods and services such as electrical power have to rise to meet future demand? The implication of the phenomena that seems to jump off the page at me is that many goods and services prices appear too low compared to prices in the financial economy, and will have to rise in the future to meet increased demand; and perhaps sooner than later. What does that say for inflation, especially on top of rising wage demands? (In November, 1997, the unemployment rate dropped to 4.6%, a 24 year low). Up, I think!
Later in this paper, we will see how this obsession for yields has impacted the world of gold.
Chapter 5
The first big indication that all was not well in the new financial economy occurred on Oct. 19, 1987. That was the day the electronic economic economy went haywire. On that day the DJIA dropped 508 points from a high near 2,250. On a percentage basis it fell over 22%, twice as great as the 1929 crash. Over 600 million shares traded on the NYSE that day, seriously over taxing the facilities of the exchange. Panic selling reigned that day. This crash was different than anything that had gone before, because we were into the electronic age of megabyte fiat money, with all of its benefits and perils. Here is what Kurtzman had to say about the legacy of the crash.
The world that was revealed on October 19 is one that never existed before. It is a world that responds to whim, worry, and abstract thought. It is a world where the only distinction between relevant and irrelevant information is whether people pay attention to it. It is a world where information feeds on itself
In this world the movement of information alone is often enough to determine events. Market busts, investment booms, and the value of the dollar are no longer determined by fundamentals but by how we feel about them. How else can it work? In a world where the flow of information is already enormous and growing daily, how else do we sort out what is relevant from what is irrelevant except by feeling? The volume of information is simply too vast to make a reasoned assessment of each bit of data that hits our screen. As a consequence, the network that has been built to field good judgment around the world (judgment that is, that must be translated into either a simple yes or no) from time to time will carry nothing but hysteria. Luckily the damage done so far has been kept within the walls of the electronic economy
It is obvious that the competition between the various news organizations to be the first with a new significant piece of news, speeds up this process. The spin that is placed on the news has also become a major factor in market behavior. In addition, the availability of this news at ever lower cost and on a 24 hour per day basis adds to the information overload. No wonder computers and software programs have been developed to aid in the fast processing of new data into market action. To the fastest with the right answer goes the bulk of the profit, with the others trading too low or high, as the case may be. The 1987 crash is now ten years in the past, but we must ask ourselves, have conditions changed to prevent it happening again? I think not. In fact, it appears things have gotten worse in the intervening years, with more volatility, more asset inflation from additional increases in megabyte money, and even more information overload. It appears it is just a matter of time before some unexpected event causes a new market crisis, and next time the powers that be may not be able to contain the crash as they did in 1987. Even in 1987, events almost turned into a disaster, but was narrowly averted. Hyman Minsky who wrote Stabilizing an Unstable World Economy, feels that the newly constructed electro-economic system that girdles the globe tends more toward chaos than stability.
Chapter 6
Up to this point we have developed a brief overview of the history of gold and money from the beginning of recorded history to about 1971. In all of those thousands of years, most of humankind has revered gold for its value as money and for its uses in jewelry, art works, and other industrial applications, which are many and varied. (This is a good point to mention that the falling price of gold in the late nineties is accelerating the use of gold in all of these applications, to the point that 1997 should show an all time record for gold usage around the world). We should add that this reverence of gold was worldwide and throughout the entire thousands of year history, from the Ancient Middle East, China, Ancient Egypt, the early South American civilizations, and India, to name a few notable examples.
It is hard to find many gold detractors throughout history, and when you do, their thinking was either flawed or just plain wrong. Two outstanding examples of this include Lenin of communist ideology, who made the statement that "the most useful purpose of gold was to adorn the walls of restrooms". His statement does not deserve a comment. The other was the famous saying of England's famous economist, John Maynard Keynes, who cynically called gold a "barbarous relic". His attitude can be assumed to represent the opinion of a typical welfare statist as described by the following quote by Alan Greenspan in 1966, who is now the current chairman of the FED.
"This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the 'hidden' confiscation of wealth. Gold stands in the way of this insidious process. It (gold) stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard."
This and similar quotes on the subject of gold by Mr. Greenspan in his earlier years clearly indicate that he revered gold and its role in the affairs of humankind. Today, however, late in his career he is the chief caretaker of the value of the fiat dollar, in a period in the United States that very much resembles a welfare state. One must wonder just how much he has been seduced by the power elite of Washington? It would be interesting to learn if he has changed his stripes, or if he still respects gold but feels it is impossible to go back to a sound money policy based on gold.
Prior to 1971 when gold was still used to back some paper money, especially the US dollar, there were two categories of gold holdings. One category was gold holdings owned by governments, or what we will call monetary gold. These holdings were exchanged between governments for balance of trade imbalances, and were seldom or ever relinquished for any other reason. In fact they were from time to time augmented by purchases from the other gold holdings market. The other gold holding category was the supply of gold mined or reclaimed each year for primary use in all of the other non-monetary gold uses. This gold market responds to the laws of supply and demand.
From earlier chapters we have seen that during the years of the sixties, the artificially low price of gold at $35.00 an ounce had stimulated huge demand for both monetary and non-monetary gold holdings. The pressure that this placed on the gold price was like the pressure that builds up along an earthquake fault line. Many observers did not recognize this pressure build up. In fact, many observers were of the opinion prior to 1971, that it was the dollar holding up the price of gold, rather than the value of gold holding up the dollar. This group forecast that when the gold backing of the dollar was withdrawn, the price would drop drastically. The lowest estimate I saw was one observer felt the price of gold could drop to $4.00 per ounce.
Events subsequent to 1971 have proven this group of people very wrong indeed. The fact of the matter is, that gold did not drop below $35.00 an ounce between 1971 and the present time when this is being written in December of 1997. Not only did the price not go down, it went up with a vengeance, due to the extreme pressure that had been build up by the dollars created up to 1971. In fact, the price of gold was in a mostly constant climb from $35.00 in 1971 to a peak of over $850.00 in January, 1980. It should be needless to say that this gold action caused a great uproar in the halls of government, and caused many changes throughout the world in society and monetary affairs alike. It is important to note at this juncture, that the free market price of gold based on supply and demand has oscillated around a price of about $350.00 since the peak in 1980 and late 1997. It is obvious from a review of these numbers that the price of gold had to rise over 24 times its value of $35.00 before the price pressure subsided, and the approximate average price since the peak has been 10 times the 1971 price.
Now it is time to examine what has happened to the overall supply and demand for gold since 1971, and also what has happened in each of the two sectors of monetary and non-monetary gold. For the next 10 to 20 years after 1971, the supply-demand picture was pretty much the same for all sectors of the gold market. Toward the end of that 20 year span changes started showing up that have changed the picture drastically. We will look at each in turn.
Use of the derivatives markets for gold were beginning to be used by some of the large gold mining firms, Barrick Gold was a stand out example. This practice has the effect of placing downward pressure on the current and future price of gold because of its impact on the futures markets.
Remember that this period also saw the beginning of the obsession for the highest yields possible on all asset classes. Early in this period, some central bankers who held gold reserves started thinking there might be a way to earn some income from that gold hoard. They came up with the idea of leasing some of their gold to credit worthy entities, such as gold mining firms that could pay back the gold from future production. The gold mining firms borrowed the physical gold, sold it in the current market, and used the proceeds as a loan for current needs. This, of course, also had the effect of increasing the current supply of non-monetary gold and placed downward pressure on prices. The central bankers earned a low rate of interest (usually 1-2%) on these loans because of the credit worthiness of the borrowers, and everyone went merrily on their business rounds. This procedure has increased greatly in the last decade.
Central bankers and welfare statists have always been opposed to the discipline gold places on their inflationary tendencies, and the higher the price, the more they hate and fear gold. So it is no wonder that they feared for the stability of their unstable fiat megabyte money system anytime there was a crisis and the price of gold shot up by a flight to quality out of megabyte money. These central bankers are very shrewd. They reckoned that it was silly to let megabyte money flow to gold when they had a weapon to counter the tendency. What they have done is wage a propaganda war against gold at the same time they have made certain that gold prices responded weakly to crisis events that historically caused the price of gold to rocket upward. This was possible by selling gold into the marketplace during a crisis to keep the price down, or alternately, to make statements that a central bank(s) was planning to sell their monetary gold or to cut their currency tie to gold. This latter ploy was very successful in the second half of 1997, when Switzerland used it. Over time they have successfully convinced the populace at large that gold is dead as money, and you are better off to rush into the bond markets or other paper securities of countries felt to have a strong currency. The US government is very desirous that as many people as possible will rush into the dollar and especially US bonds during a crisis, so that our balance of payment deficit will be masked. It doesn't seem to matter to most people that they are rushing from one intrinsically worthless fiat megabyte currency to another, so the ultimate safety of their wealth is questionable. We must ask ourselves how long these ploys will work? My opinion is that it is only a matter of time until some very serious crisis will come along to change this complacent scenario.
Still farther along in this process, as we have gotten closer to the present time, these same central bankers who initiated gold lease programs looked around and realized that they might be missing out in this new era of obsession with high rates of return. Why should they be satisfied with 1-2% returns when they could earn 6-7% on fiat megabyte money they obtained from the sale of their gold. This probably occurred to them when they saw large hedge funds come to them and borrow gold, only to see the hedge fund turn around and sell the gold and buy US bonds with the proceeds. Nice deal for the hedge fund, pay 1-2% and earn 6-7% on sizable sums of money. We should notice that this operation works best in a falling gold market, which the sales of the gold borrowed from the central banks fosters. It wasn't long before the central banks decided to sell some or all of their monetary gold, which has further exacerbated the drop in gold prices. They had already convinced most people that monetary gold isn't needed, and in turn convinced themselves. In this scheme of things everyone was happy for awhile, the producers, the central banks, and the hedge funds. It is only after their machinations have dropped the price of gold so low that it is affecting the health of the gold mining sectors throughout the world that the gold producers have started worrying, and perhaps a few central bankers in places like Australia and Canada who have seen their gold sector firms come into trouble.
Let's now turn the spotlight on the non-monetary gold sector for awhile. The huge run-up in gold prices between 1971 and 1980 caused a flurry of gold exploration and the opening of new mines as the industry became more profitable. From 1980 until about the end of 1995, the industry adjusted their production to accommodate a price that averaged between $350 and 375. It was about this time that the direct central bank sales began in earnest and this was on top of the continued leasing and hedging operations already discussed. This had the effect of greatly increasing the supply of gold to the non-monetary sector of the market and distorting the supply-demand balance that had been in effect since 1980, pushing gold prices down to or below the cost of production. The exact cost of gold production is a hard figure to pinpoint because of the diversity between mining companies and various ore bodies. The Dec. 8, 1997 edition of Barron's had this to say of production costs and mine closings.
The average gold producer extracts the stuff at a cost of $315 an ounce. At $300 an ounce, he (Kjeld Thygesen of the Midas Gold Fund) says, 30%-40% of the world's production is operating at a loss, while 60% of South Africa's production does so. There have already been closures by Barrick Gold, Royal Oak, and by Pegasus Gold, which shut down its flagship Mount Todd mine in Australia. Expect more if gold drifts lower
The consequences of all of these factors is that the gold mining industry is in a state of turmoil and change. Mines are being closed and more are likely to close if prices stay this low or go even lower. Kjeld Thygesen of the Midas Gold Mutual Fund had this to say in the Dec. 8, 1997 edition of Barron's.
So much gold has been sold by central banks and by hedge funds expecting further declines that the outstanding short position equals more than two years of mine production
At the same time demand is going up as the price goes down, and will in all likelihood be an all time record high in 1997. The marketplace does not care that the price is artificially low because of the mismanagement by central bankers due to the selling off of their monetary gold. The market happily accepts the windfall bargain price and increases gold's use in jewelry, industrial applications, and perhaps other new uses that were not possible at a higher price. If you go back to the prologue and review the many excellent properties of gold, it is easy to see that lower prices could open up a myriad of uses. How long will this continue? That depends on many factors. These include:
- Will the central banks that are selling gold continue until it is all gone, or will they wake up and realize they are selling their birthright, so to speak?
- Will other central banks, who have not fallen into the trap of the interest rate return obsession and have not sold gold, continue this policy? Or will they start selling gold on a "me too" reflex as Argentina did in 1997? Or will they perhaps realize that gold has been artificially pressed down in price and add to their gold hoards? My answer to the latter question is that in all probability, China, Japan, and some other Asian nations who are relatively gold poor and relatively dollar rich, will welcome the chance to change dollars for gold in a quiet way. We will return to this idea near the end of this paper.
- Will a crisis in the world change people's perception of the desirability of holding fiat megabyte money? If so, where will they turn? Perhaps gold? If not gold, what?
Over the last 5,000 or more years of recorded history, when events changed the world and turned it upside down, people with gold have come out far better than those holding fiat paper money. Will it be different with megabyte money? I personally doubt it. To see the truth of this premise one does not need to go very far back in time. Our own South after the Civil War when Confederate paper money became worthless; Germany in the early nineteen twenties; much of Europe in WW II; Russia after the wall went down; Mexico just a few years ago; and in late 1997, as this paper is being written, over much of Asia. Will there be conditions at various times and places around the world in the years to come where gold will save peoples wealth, and perhaps even their lives, better than fiat megabyte money? You can bet on it. If people don't think they may be vulnerable at some future time, they are ignoring the facts of history, both old and current. In the uncertain and unstable world I have tried to picture in this paper, and that is depicted in the suggested additional reading, you can bet on a crisis rearing its ugly head periodically and randomly around the globe. You may not want to take my word on this, but you should respect the opinions of the many knowledgeable, intelligent, and savvy people who have written the references, or been quoted in them.
It will at this point be instructive to examine the price action of gold with the other precious metals. Gold has been in a general downtrend for two years. How have platinum, palladium and silver behaved during this period? First let's take a look at platinum and palladium since something similar has happened to those markets as has taken place in gold, but for a different reason. When the Berlin Wall came down and threw Russia into a tailspin, the overvalued Ruble depreciated very rapidly. This necessitated the Russian officials to hurriedly search for a means to obtain hard currency so they could stay afloat. They had a hoard of gold, platinum and palladium left over from their cold war stockpiles. Russia happens to be one of the two biggest producers of platinum and palladium in the world. South Africa is the other. Since the fall of the wall they have been selling their stockpiles of platinum and palladium thereby swelling the supply and placing more pressure on prices than would be expected from just current mine production alone from around the world. Early in 1997, they started to near the end of their stockpiles, or at least reached a point where supplies were so low they needed to stop these excess sales. As one would expect, prices of these two metals bounded higher during 1997. In fact, palladium made a new 18 year high over $220.00 per ounce, exceeded only once in history in 1980 when it soared to $350.00 per ounce when gold, platinum and silver also made new all time highs. It appears from this price action that one can assume there is excellent demand for at least these two precious metals and that much of the prior weakness was caused by stockpile selling. The very same thing that is currently happening in the gold market. See Chart 3 for gold prices over the last two years, Chart 5 for platinum, and Chart 6 for Palladium.
Now look at silver. A comparison of silver and gold price action over many years suggests that they move up and down roughly in tandem. Silver differs from gold in one very big way. There is not a big overhanging stockpile of silver anywhere in the world that can be tapped easily to depress prices. The central bankers have already sold off their silver hoards. Silver in 1997 has been depressed by its association with gold, but it has recently shown independent strength. While gold has dropped to 12-13 year lows because of the factors mentioned earlier, silver has actually bottomed out and rallied during 1997. The chart patterns are vastly different. See Chart 4 for silver prices for the last two years.
It does not take too great a leap of imagination to see that gold is being artificially held down by the forces already mentioned, and an observer does not have to go too far out on the proverbial limb to predict that at some future point in time, when the artificial pressure on gold prices is released, that gold prices will push higher just as the other three precious metals have done recently.
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The remote possibility that these numbers can be correct, is enough evidence to make it easy to understand why the central bankers and high government officials around the world want to denigrate, denounce, discard, disown and dislike gold, plus keep prices low. It makes one want to take time to consider what the implications of anything remotely resembling this happening might be. The last time gold had been held down artificially for 37 years. This time, so far, it has only been 17, which may lessen the next rise. On the other hand we have asset markets that have reached such lofty levels, where no less an authority than the FED Chairman has described the situation, as long as a year ago, as "Irrational Exuberance". So who can tell? Let's not lose sight, while we are pondering the question, of the trillions and trillions of fiat megabyte dollars, yen, marks, and what have you, that are whizzing around the world electronically every minute of every hour of every day. They have to end up buying something, and it might just be gold one of these days.
Part - III next week
Copyright © 1997 - 1999 vronsky and westerman