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Dogma vs Fact

April 2, 2003

A "frame of reference" is essentially a prejudicial mind set which enables one to put data into perspective.

For example, a man who is six foot in height is only considered tall because of the frame of reference that the "average" man's height is less than 6 feet.

There are some people who have the ability to retain large volumes of data without having any frame of reference at all. These people tend to have good memories but are not necessarily possessed of any remarkable level of understanding.

At the other extreme, there are people who "reach" for a frame of reference to minimise the need to retain detail. These people tend to get locked into answers in search of questions, and try to "force" the details that they process to fit into their frames of reference. These people (who are essentially followers of dogma) tend to be described as dogmatic.

With age and experience, frames of reference tend to become modified so that they can accommodate apparently non conforming data.

With the above in mind, it is relatively easy to understand that most "gold-philes" will subscribe to a frame of reference which, in essence, looks something like the following:

  • Gold is a precious metal
  • It has been used as a medium of exchange for all of recorded history
  • It is a store of value
  • It is a hedge against inflation (debasement of the value of fiat currency)
  • It will be the ultimate fall back currency when confidence in fiat currencies is lost
  • Notwithstanding the debasement of fiat currencies in general and in the US Dollar in particular, the primary reason that the gold price - expressed in US Dollars - has not risen to compensate, is that it has been artificially suppressed by Central Banks.
  • The reason the Central Banks have co-operated with each other in the management of the gold price is that they have vested interest in protecting the viability of their relative domestic economies in particular, and in the international economy in general.

With this frame of reference it has been possible to "rationalise" why the gold price has not outperformed commodities in general, and it is also possible to argue that the gold price should always move inversely to the US Dollar.

It would also be possible to "rationalise" that if the US Dollar were to weaken, there should be a shift of capital out of the US Dollar and into other currencies which should be generally rising in price relative to the US Dollar. I.e. if the other currencies rise but the gold price does not then it can be "rationalised" that our frame of reference still holds given that an explanation for this failure to rise must lie in the Central Bank's behaviour.

But there may be a problem with this frame of reference - which is this:

If there is a shift of capital out of the US Dollar, then "Capital" should become relatively more difficult to come by within the USA. When capital becomes more difficult to come by, demand should exceed supply, and the "price" of that capital should rise. I.e. For the frame of reference to hold true, interest rates (and bond yields) should move inversely to the US Dollar.

Of course, it could be argued that if the economy is slowing down and/or the Federal Reserve is increasing the supply of money then demand for money will not exceed supply and the price of money need not rise.

But if the supply of money is rising (being inflated) this inevitably leads to a degradation in the value of that money if the rate of expansion in supply exceeds the rate of productivity growth. In these circumstances, the price of goods and services - when expressed in that currency - should rise. (ie Price rises in general should manifest)

And if price inflation manifests then lenders will earn negative returns unless they receive higher interest rates. So it follows that if the Fed were to "flood" the market with cash, the price of borrowing should rise to compensate for inflation.

The only logical reason that price inflation will not follow monetary inflation is if the velocity of money slows - thereby reducing the demand for money. Ie If printing more money does not lead to higher amounts of money in actual circulation.

With the above in mind, some possible "cracks" in our frame of reference begin to manifest:

  • If the USA economy is slowing, this would be accompanied by a reduction in the velocity of money and could account for a lower demand for capital than is available. This could the reason that interest rates are remaining low which, in turn, could be the reason the US Dollar is falling relative to other currencies. Further, if a rise in other fiat currencies relative to the dollar is not accompanied by a similar rise in the gold price, perhaps this is a reflection that there is no real loss of confidence in ALL fiat currencies.
  • If there is no loss in confidence in fiat currencies, then perhaps the reason the gold price is not rising is that it might still be perceived as a commodity by the market at large.
  • If deflation is setting in because there is a general slowing down in demand, then the demand for all commodities - including gold - will slow. When supply exceeds demand, prices fall. Maybe the reason that the gold price is not rising is that the demand for gold (ignoring artificially created speculative demand) may be falling.
  • If gold is in fact a store of value, but the real reason that the USA Dollar is falling is related to a loss in value of that currency relative to others (as opposed to a loss of confidence in all fiat currencies) then, if this is accompanied by falling prices in general, there is no need for the price of gold to rise because relative to the prices of other products and services gold will still hold its value. I.e. You can still buy a loaf of lower cost bread for the same weight of lower priced gold.

So the question boils down in the end to this:


We need to beware of dogma when answering this question. Yes, our frame of reference is "set" that gold is - in the end analysis - a currency, but the facts seem to fall outside the frame of reference, and there is an argument - other than price manipulation - that can be put forward as an explanation as to why the gold price has not risen.

That argument is well supported by a relative strength chart of gold vs $CRB (commodities in general), and I include here a web reference site to anyone who would like to check the facts.$crb,$gold

If you expand the chart back as far as it will go, you will see that - since January 1999 - BOTH gold AND $CRB have risen approximately 15%.

Yes, there was a period up to September 2001 when gold UNDERPERFORMED relative to commodities, and it could be argued that this period was characterised by manipulation of the price of gold. However, since that date, both gold and commodities have been moving in virtual lockstep.

Of course, we could be dogmatic and argue that gold is still being manipulated, but because the gold price is virtually following the $CRB it would require a virtuoso performance of manipulation to achieve such an accurate outcome.

No, it is less dogmatic - and more rational - to conclude that (at least to date) gold has been behaving like a commodity.

Now this is very interesting.

In terms of the gold-phile mindset (and I am one of these), the reason we got into gold in the first place was "debt levels". We saw a catastrophe brewing and have been arguing that if a catastrophe manifests in the form of a debt implosion, then this might inevitably lead to a loss of confidence in Central Bank policy in general , and in fiat currencies in particular. Under circumstances such as these, gold would soar upwards even in times of deflation because "gazzilions" of dollars of fiat currencies would be piling into gold (and silver) and demand would exceed supply. Some of us (myself included) bought gold as an insurance policy against a loss of confidence in the system. Others, who may be a bit more dogmatic, bought gold because it is going to $3,000 and fortunes are to be made when one "buys low and sells high".

There have been many (including myself) who were expecting the gold price to start rising strongly when the Dow Jones entered a Primary Bear Market, because we subconsciously argued that a Primary Bear Market would lead to large losses in equity portfolios and an inevitable reduction of both wealth and income. In turn, this would lead to an inability to service the debt, and therefore a falling Dow should be accompanied by a rising gold price as the gold market started to anticipate an implosion of debt levels.

A couple of weeks ago I decided to start thinking "outside the box" of my prejudicial frame of reference. If the FACT is that gold has been behaving like a commodity, and the FACT is that the Dow is falling but gold is not rising as expected, then there must be an explanation.

At this point, I would remind readers of a question that has been generally on the lips of most gold-philes:


Here is a possible explanation:

I wanted to see how the Dow Jones was moving relative to interest rates, and I analysed the relative strength of the Long Bond yield and the Dow Jones

Here is the relevant Relative Strength chart:$indu,$tyx

You will see that, recently, they have been moving in lockstep. Further, if you expand the chart back to January 1999 you will see that since that time, the Dow has fallen about 10% and the Long Bond Yield has fallen about 5%

But, and here's the thing, the CAPITAL VALUE of bonds moves inversely to that of the yields, and so it follows that the capital value of treasuries has been rising even as the capital value of equities has been falling.

So, the question arises: What is the relative size of these two markets?

Well, I had to do a bit of digging, but here's the answer:

According to the International Monetary Fund statistics, as at December 2000, the gross value of all US debt securities was $17.1 Trillion Dollars with $15.1 Trillion of this number held domestically

According to the IMF, the gross value of all US Equities as at 2000 was $15.8 Trillion with $14.1 Trillion of that number held domestically.

So, it would appear that we might have an answer as to why there is such stubborn bullishness: With the debt and equity markets having been of a similar size as at 2000, and with bond yields and the Dow having moved in virtual lockstep, to date the OVERALL capital losses have been relatively small.

Of course, it is a bit simplistic to argue that Bonds move proportionately up when yields fall, given that there is an adjustment based on an argument called "yield to maturity".

Nevertheless, I am satisfied that I understand the reason for the stubborn bullishness:

OVERALL within the US economy, the pain of financial loss has not been sufficient to modify the dogmatic viewpoint of the equity bulls.

In essence, that is also the reason why gold has not yet started rising strongly. If the losses have been muted, the threat of debt implosion is not yet "real", and so that would explain why gold is still being perceived as a commodity.

Does all this negate the gold-phile frame of reference? NO IT DOES NOT, and here's why:

Dow Theory has two core elements, which are roughly described as follows:

  • When markets are overvalued or undervalued there is a PROPENSITY for a change in Primary Trend direction
  • The change in Primary Trend direction can be recognised when BOTH the Industrial Index AND the Transport Index have confirmatory break-ups (or downs)

Keynes argued (correctly, in my view) that "the markets can stay irrational for longer than you or I can stay solvent", and so it is not sufficient for values to be out of whack. There must be confirmation of a technical nature.

(Note: It is important that I acknowledge Mr Richard Russell as having been the source of my understanding of Dow Theory, and I thank you for that sir)

Now, of even greater importance is to understand the "personality phases" of the markets. Primary Markets move in a 5-3-5 pattern (which I do not believe can be as easily forecast as the Elliot Wavers would argue, notwithstanding the brilliant Mr Fibonacci). In a Bull Market, there will be five upwaves and three (corrective downwaves); and vice versa in a Bear Market.

The FIRST wave of any Primary Move is typically accompanied by a lack of belief (or a presence of disbelief) that there has been a "structural" change, and that would be consistent with the stubborn bullishness that we have had to date in the current Primary Bear Market.

The FIRST reaction wave is typically accompanied by rationalisations of "I told you so" by the dogmatists (in this case the "hold for the long term" dogmatists), and so the enthusiasm accompanying this first reaction is reminiscent of an upwave within a mature Primary Bull market.

And all of the above leads to the following conclusions

  • There is still too much cash around, and still too few losses having been suffered, for the market as a whole to generally be worried about an unravelling of the financial system
  • With this in mind, Gold remains firmly entrenched as a commodity in the "frame of reference" of the MAJORITY of investors
  • This frame of reference will only start to become challenged when large losses begin to manifest OVERALL (ie the sum total of all equity and debt capital movements starts to become significantly negative)
  • This, in turn, is unlikely to manifest until the equity market enters the SECOND down-leg of the Primary Bear Trend which, by definition, can only manifest after FIRST reactionary up-leg within the Primary Bear Market.

And this leads to the question: What will give rise to the first Primary upward reaction?

Well, here's my hypothesis:

  • The US politicians will be highly motivated to have a benign political environment leading up to the US Presidential elections.
  • A fall in the oil price will be highly stimulatory to the US economy in the short term. If a fall in the oil price can be engineered, then an "Indian Summer" period of economic stability will manifest which, in turn, will provide the benign political environment.
  • If the fall in the oil price is accompanied by a "sigh of relief" following a positive outcome of the Iraqi caper, the investment "mood" will become generally positive.
  • But this mood change will be temporary. Values are still not present, and extraordinarily high debt levels still are present. This still needs to be unwound. Further, Dow Theory will not call for a change in the Primary Trend unless both Indices reach for new highs. I see this as highly improbable.
  • In a previous article I made reference to our entering the "fourth turning" of a 75-100 year "Saeculum". I believe we are now leaving the third "unravelling" season, and commencing the fourth "crisis" turning - which season may last up to 20 years before it culminates in a catharsis (possibly but not necessarily a World War)
  • During the fourth (crisis) season I anticipate that the power base of the USA within the world's society will wane, and a new power base will begin to manifest.
  • There is an argument that the seat of this power base could shift to Asia (in particular, China)
  • There is another argument that a United Europe could become the seat of this power base.
  • I anticipate that the "catharsis" will manifest when this question is finally resolved.

And the Bottom line is this:


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