Weekly Gold Market Outlook
A Gold & Currency Digest
The Inflation Conundrum?!
- No genuine "tightening" has actually begun, yet (money and credit still growing - only threats exist so far)
- Hedge funds do not add volatility, they reduce it (volatility emanates from central banking policies or dumb money)
- Gold stock valuations are rich for current gold prices, but gold is still the most undervalued commodity
- The bulk of long equity positions remain outside gold sector (oil, income trusts, real estate, and even base metals)
- Traditional foreign dollar buyers (esp. official) are losing their enthusiasm for continuing the policy
- Commodity and consumption boom is more of a monetary phenomenon than a real growth phenomenon
- Leading non-gold equity sectors / real estate have benefited more from easy money policy than gold sector, so far
- USd getting most of its chart support relative to Asian bloc currencies, including Rand and AD
- Seasonal trends are out of whack this year
- Tough 'talk' on inflation has the effect of dragging the inflation genie out into the public domain
- Wall Street is raising its interest rate forecasts
Number (3) is a soft fact because it is a statement of value that depends on the correct assessment of monetary facts.
JP Morgan issued a call where they said they were more bullish on gold than the other commodities.
Of course, they overlooked the core reason that this would be true, which is that the inflation in money and credit is the main source of the growth in "demand," and that this inflation is the very goal of central banking policy in the first place.
But one could simply add this to the rest of their otherwise sound fundamental argument.
To reiterate, I've said that there has been significant damage to the intermediate gold (equity) trends, that I'm not sure whether we've seen the correction lows yet, but that the worst of the declines are probably behind us.
I still agree with that view.
However, I believe that gold stock valuations leave much to be desired if the gold price sequence that began in 2001 has completed. If, as the recent LBMA poll suggests, gold slowly recovers its recent highs over the course of one full year, we would be wary of retaining any significant gold stock exposures. Clearly, then, the 64 million dollar question is, has gold completed this sequence, or are we off to new highs as the economic 'data' turns south faster than expected?
Usually, the 'data' will tend to lag real-time developments, so I'm not sure how that'll play out.
I also said that I think the tightening 'threat' (i.e. not action) has some legs because the economic 'data' has been strong, but that much of this 'good' economic data is the product of central bank 'accommodation' (read: inflation).
I must emphasize that the Fed has not yet stepped on the brakes. Many people seem to think that because it has raised interest rates consistently over the past two years that it is stepping on the "brakes." This is manifestly untrue.
Stepping on the brakes means that it actually stops expanding money and credit. As long as the monetary aggregates continue to grow the interest rate determined by the Fed will be lower than the one that would prevail if it didn't intervene.
In other words, despite the fact that the FOMC has taken the word "accommodative" out of its statement, it still remains accommodative. Remember, money supply growth rates are not determined by interest rate levels. Rather, interest rates are influenced by the buying and selling or other activities of the central bank as they affect reserves and deposits.
These things are important to clear up because they tend to form the premises of investor's conclusions, and actions.
Thus, the statement: "When the Fed stops stepping on the brakes I'll buy gold" is simply wrong-headed.
It hasn't started! It's tooooo s-c-a-r-e-d. I dare 'em to. I mean, it'll be good for my S&P short anyway.
So when we say that the tightening policy has legs, we really mean that the tightening "threat" has legs.
It's really just a show, albeit one that seems to have already convinced many would be gold bulls.
A bona fide tightening policy is likely to produce an all out bust, which is not so bad for gold because such an outcome spells the end to the tightening resolve. It is the illusion of tightening, its plausibility, that is most bearish for gold.
Right now the hawkish rhetoric may have scared away prospective investors that were just about to jump off the sidelines and into the gold pot. These investors were probably not convinced of the inflation problem in the first place, and now they're seeing what appears to be a vigilant policy shift. The expectation is that by tightening now, the Fed can wring the inflationary excess out of the system without affecting the core growth story. So why buy gold stocks?
Consequently, the dollar has strengthened somewhat, and the gold shares have taken the brunt of the equity decline - sharing this space with the homebuilders and technology sectors. The other commodity sectors and the financials have held up better… so far. I believe this is a function of the psychology as described above, rather than real fundamentals.
Moreover, I believe this conundrum would reverse sharply if the Fed actually began to step on the brakes.
Right now it is talking tough while keeping 'some' pressure on the gas pedal, which is supportive of the growth data and bearish for the inflation trade. But when (if) it steps on the brakes it is possible the growth trade would unravel, followed by the Fed's resolve to continue tightening. Look, gold bull markets occur alongside rising interest rates. This is a historical fact. It happens because the central bank is increasing interest rates slower than it should - slower than the pace at which the value of money is falling - slower than the real increase in time preference rates. If the interest rate is growing faster than the general price level (CPI, PCE, etc.) some analysts will say that the increase is "real."
But this is true only if these indicators properly reflect the decline in the value of money, which they rarely do. The Fed often points to the inflation indexed bond yield as a measure of what is happening to real yields, but this yield is based on the market's expected growth in those price indexes. The bottom line is that as a gold investor, you better get used to a hawkish Fed. Who among you really believed that the Fed would continue talking dovish all the way to US$2000?
From here on in, the gold trade isn't going to be as easy as buying when the Fed is easy and selling when it is tough - it is going to be buying gold when the Fed talks tough and doesn't or can't mean it… or when it does, and causes a crisis - and it is going to be selling gold in anticipation of the Fed tightening its rhetorical policy stance, or when we arrive at a point where the Fed does mean it, which in our view is when it has much less to lose from tightening than it does today.
Using MZM as the best indicator of broad money growth made available by the Fed going back to 1959, the Fed actually tightened in the following years: 1967, 1970, 1979, 1989, and 1995. Except in the first two instances (1967-1970), in the others, the S&P PE ratio ranged between 7 (1979) and 15 times (1995) "trailing" earnings. Today the S&P 500 has been selling for between 15 and 20 times trailing 12 month earnings, and more than 15 times 2006 'expected' earnings. This value is rich if the bulk of the gains in earnings are the product of monetary expansion, as opposed to actual productivity.
The tightening in 1995 was the only one that did not result in a bust in financial assets. The 1967-70 tightening, where the market's PE was similarly in the 15-20 times earnings range, lopped 30 percent of the value of the stock market.
During 1979 and 1989, the impact on stock values was much more benign because the PE ratios were, respectively, 7 and 12 times trailing earnings at the time. In these times, the Fed had much more to lose by not tightening.
Now, Greenspan has partly taken credit for the 1995-99 bull market in stocks insofar as he said that the Fed's tightening during 1995 created the ideal monetary backdrop (stability) for the subsequent growth and exuberance to take hold.
But, the US economy itself deserved that credit. The Internet was only then just finding a solid footing in the homes of average Americans, and the productivity engendered by the information & technology revolution was a boon to growth.
Moreover, the previous monetary policies of the Fed (i.e. between 1986 and 1995) were not nearly as egregious as they have been over the last decade. In the former decade, MZM expanded by a total of 77%; while in the recent decade this statistic has expanded by almost 140 percent, causing one bubble after another - first in the exaggeration of technology values, then real estate values, and now in some of the base metals and foreign (non USd) currency values. While the PE ratio of today's S&P 500 is not that much more expensive than the 1995 PE ratio, the quality of earnings is different.
They are worse, and more inflationary, rather than the product of genuine productivity growth - in our view.
The distinctive characteristic of the last five years in the markets has been the equation: inflation > productivity.
In other words, the monetary expansion has been more influential on the bottom line than productivity. Furthermore, the malinvestments have had more time to build, without liquidation, bubbles on top of bubbles - that's the current problem.
This problem was not so pervasive in 1995. The US dollar was weak in the early nineties, it is true, but the monetary environment did not provoke inflation calls like it has today. In the late nineties, productivity was so great inflation was considered to have all but died - despite its ongoing buzz beneath everyone's radar. Greenspan was not yet Easy Al.
This whole situation is different today. Boy is it different.
Saving the US dollar, this time, will probably take much more resolve than the Fed can afford.
In any event, the test to our hypothesis calls for a recovery in the HUI/SPX ratio and renewed weakness in the Dow/Gold ratio. In other words, when the tightening notion begins to cause greater erosion in the broader equity averages than in the gold stock averages, or when the price of gold shows signs of greater resilience than the broader stock market, this will be the time to reload. However, as long as the broad market holds up better than the gold sector, and the economic data does not produce general criticism over the Fed's new direction, the inflation trade is on hiatus. But, it remains my view that the burden of proof, circumstances being what they are, remains in the Fed's hands… it has to show that it is willing to actually tighten and continue tightening through any potential collapse in the leading economic indicators. The market should not have to prove the fact that the Fed is the engine of inflation, and that it exists for that purpose alone.
It's not like there is a paucity of evidence in that direction, after all.
So long as the fundamentals are sound, corrections can only be healthy.
Editor - The GoldenBar Report
June 29, 2006
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