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Inflation Is A Constant
 We
appear headed for another test of the $360 level on gold, as the dollar
bullish environment on Wall Street extended yet another day.
The Dow continues to defy our bearish call,
and surged another 116 points to close at 9039 Wednesday.
The bulls made a higher intermediate high
intraday, but closed four points below December's (intraday) high, so
I wouldn't call it a signal yet, even though it might be by Friday.
Moreover, key intermediate resistance is
at August's (2002) high - 9077.
The odd thing about this rally is that
the bulls are cautious. The headlines read "is this for real,"
rather than, "choo, choo, the train's leaving the station."
Even Tom Gavin - whose remaining clients could well be hanging on to the
stocks they bought three years ago - sees a pullback here, as well as
a much less rewarding stock market environment going forward than was
the case during the nineties.
Our sentiment indicators are mixed. Some
are showing extreme bullish sentiment, while others suggest there is room
for this sentiment to grow. None suggest too many bears.
 The
CBOE's put/call ratio suggests there's room for bulls to get more bullish.
The indicator set off an incorrect sell
signal in April. Then a correct one
a month later - in the middle of May.
But it was immediately followed by a buy
signal - too many bears.
Since then, it appears bullish sentiment
has been rising more cautiously. I don't know what's going to happen next.
The shorts might as well be careful here.
The environment isn't unfriendly, but it might pay to wait out either
a crack in momentum or a clearer reading from the sentiment indicators.
In the near term, much may depend on the labor news this week.
Meanwhile, the bond market isn't letting
up. Players could be acting out a little war anxiety, or they may be betting
on a bad labor report, or they are bullish on deflation and the prospect
of a Fed yield cap, or they're just momentum trading.
At any rate, whatever is driving the bond,
the strength in the bond is driving stocks, higher. As for stocks, whether
it's falling yields, or the falling dollar, or the recovering economy
or profit boom, there is inflation everywhere at the moment.
That much we can all agree (defining it
as too much money/credit) I hope.
Indeed, as long as it isn't perceived,
yields can be managed. And as long as yields can be lowered, or kept low,
stock values could rise further - at least until they approach full valuations
(which we guestimate at about 1050 to 1100 for the S&P 500 today;
don't ask what the other side of that range is).
I believe the falling bond yield is the
single most influential factor in this stock rally thus far. So
it shouldn't surprise you to see the Dow continue to rise so long as yields
remain low, or fail to discount the true inflation picture.
And as long as it continues, it's bullish
for the dollar.
My main outlook for the Dow is that the
rally will end when yields spike, which I argue they'll do when the market
begins to discount the inflation picture as we see it today.
But so far the stock markets continue to
inch higher, with hardly an impact on bond yields. What gives? What's
the rationale for buying bonds offering yields near 45-year lows when:
- the dollar is reeling,
- the budget deficit is soaring,
- the trade deficit is soaring,
- forward and trailing PE ratios for the
S&P 500 are still near record highs,
- gold is near six year highs,
- commodity prices rose at their fastest
pace in 20 years in 2002, and
- monetary aggregates have been growing
at their fastest pace in two decades
I can't stress enough that productivity
alone can't sustain these RECORD bearish imbalances, or divergences.
Neither can the historical record find many examples when during such
conditions bond yields continued to fall.
So we have to look to unconventional explanations,
such as the possibility of deflation, or manipulation, or the Fed's forecast
use of unconventional tools, or even delusion.
Gold Stocks, Inflation, Yields, and
the DJIA in the 20th Century
Gold stocks have been surprisingly
strong in spite of the dollar's tiny bounce this week. Even Wednesday
as gold prices fell, and the dollar recovered some ground against the
Euro, Swiss Franc, Rand, and Mexican peso - it rose sharply relative to
the latter two - gold stocks gained.
 Newmont
led the S&P gold sector index to a higher intermediate high, and now
approaches last June's high at $32.75 for Newmont (and about 81 for the
index).
They closed at $30.87 and 72.7 respectively,
which are their best levels since.
Still, the picture was mixed in this sector
Wednesday. Decent gains in the blue
chips were offset by losses in the speculative end of the market.
Overall the charts of gold stocks aren't
very telling. There has been an increasing bullish bias within the one
year trading range most of them have been stuck in.
We were asked by a client to find some
data on how gold stocks had performed during the seventies environment
- which happens to be our model for the future.
So let's recap and define our model briefly.
First, we assume that inflation is a constant.
There is no deflation in our model (which I think is reasonable so long
as there is central banking, an overvalued currency, and in light of the
evidence). There is only an ongoing currency devaluation occasionally
interrupted by the consequences of an oversupply of commodities - after
their prices rise too fast - which also often provides the conditions
for a new monetary boom to take place.
Ludwig von Mises said in 1952:
For there is no doubt that
what we have experienced over the last hundred years was just the opposite
(of the general tendency for prices and wages to drop), namely, a secular
tendency toward a drop in the monetary unit's purchasing power, which
was only temporarily interrupted by the aftermath of the breakdown of
a boom intentionally created by credit expansion - from the 1981
edition of the Theory of Money and Credit, pp. 457, The Principle
of Sound Money, from section 2: the virtues and alleged shortcomings
of the gold standard.
This chapter was written
in 1952, several years after the original publishing of the book. The
parentheses are mine.
This (interruption in currency debasement)
was the case after WWI, after WWII, and after the seventies era of soaring
prices ended in about 1982 (reference our earlier categorizations of booms
and busts in the 20th century). I don't have clear 19th century data,
but according to Mises' data, such cycles have apparently been the case
since the 1850's.
In other words, each of the boom periods
comes about "after" a sharp devaluation in the dollar has already
occurred.
More specifically, our model assumes that
said banking system grows too much credit, which is followed by a monetary
debasement once the monetary boom fails to sustain any further increases
in paper (stock and bond) values - at the margin - which then results
in the rise of all remaining prices as the currency fails and the central
bank remains committed to the credit expansion (i.e. as the prior boom
busts).
Then, if the bank decides to abandon its
loose policy, or after the currency has fallen too fast and commodities
are overproduced, there is the opportunity for a new credit expansion
to take root at a much lower plateau for the currency, which in time will
give way to a new bust, and devaluation.
This is the history of our monetary system,
so I don't see why we should abandon that model just because the new fad
is deflation.
Note the long cycles for interest rates
(yields) in the chart above.
Going back 200 years, according to data
from Global Financial Data, the Treasury note has seen four bull cycles
(yields falling) and three bear market cycles (yields rising) ranging
anywhere from 15 years up to 40 years in length.
Theoretically, these cycles should match
the boom-bust (credit) cycles outlined earlier, but in practice they are
distorted between 1933 and 1966. Otherwise, the reality confirms the theory.
Thus, whether bond yields rise or fall
depends on where the currency is in its repetitive cycle of devaluation
over the long term.
When the dollar is in devaluation mode,
it normally results in rising inflation expectations (as well as war by
the way). And when the dollar is plateauing, if you will, it coincides
with disinflation trends (and the peace dividend). But the whole time,
the monetary aggregates are expanding, except for the odd deflation scare
here and there.
Note in the chart below that gold stocks
began to rise even in the 1950's (they rose in the mid thirties as well,
but I couldn't get the actual data all the way back that far). Nonetheless,
arguably the first meaningful wave in the subsequent 20 year bull market
for gold stocks occurred from 1960 to about 1968.
Unlike the current gold stock cycle, which
didn't get underway until after the Dow peaked in 2000, the market back
then appeared to factor the inflation sooner.
Note in the chart above that the S&P
PE ratio peaked by about 1961.
But for a small deflation scare as M3 slowed
to a crawl in 1968, there was ongoing inflation, and yields rose to reflect
it by then.
What was happening, according to our model,
was that the credit cycle was breaking down. Gold and bond markets began
to discount it. And by 1971, when the dollar was allowed to float, it
proved those markets right by collapsing.
That devaluation announcement kicked off
the second wave in the gold share bull market, and it coincided with a
third run in the Dow to the old 1966 peak. But it ended after the Dow
bottomed in 1974. The third wave began in about 1977, as the Dow and dollar
failed again.
Some important observations include:
- The entire bull market in gold stocks
was marked not by a period of rising inflation, which was a constant,
but of rising inflation expectations (implied by rising bond
yields 1947-1981), and currency debasement
- There is a strong inverse relationship
between gold share values and broad market values (even stronger relative
to earnings multiples)
- There is a strong positive correlation
between bond and broad stock market values (or between bond yields and
gold share values)
- The long term trend in prices and currencies
reveals Mises was right about a secular dollar devaluation interrupted
by boom periods - usually manifesting in credit expansions
- The cycles in yields and dollar devaluations
or plateaus last anywhere from 15 to 40 years - they average about 25
years (the current one is 20 years old)
- The gold share bull market began after
the major market peak this time around, while it began six years ahead
of the sixties peak last time
- The only two periods since 1959 where
deflation was actually a threat were 1968 and 1992 - in both years,
gold corrected, as it should (and as opposed to some of the popular
arguments today)
If we used the seventies as a model for
the most likely direction of the economy today - which I think is very
appropriate - and assumed a similar devaluation in the dollar (and bull
market in gold), the upside in gold shares is probably enormous. According
to the extent of gains in the Barron's gold stock index back then, we
could expect up to a 20-fold increase in the value of gold stocks on average
over the next ten years or so.
Maybe the AMEX Gold bugs index will go
to 1000. I don't know. For now, we'd be happy with 225. I think much depends
to what extent the Fed can fool people from perceiving the inflation for
what it is - a constant.
If you accept that equity valuations
(as opposed to simply stock prices) have mostly peaked, and you reject
the deflation model, the bulk of the evidence suggests that:
- Gold stocks are on their way to higher
ground (in their first wave so far)
- The dollar will continue to devalue,
and
- The 20 year bond bull market is nearing
an end
Ed Bugos
Editor - The GoldenBar Report
www.goldenbar.com
June 6, 2003
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