GOLD: Will Bulls Or Bears Prevail?

November 6, 2014

First: A Small But Not Irrelevant Distraction,

change in central bank gold reserves by country

I had to pinch the above graph from an informative article written by a writer named Grant Williams on the Swiss Gold Initiative, the subject of a referendum in roughly 30 days, spearheaded by Swiss MP Luzi Stramm and fund manager and writer Egon von Greyerz.  Mr. Williams is correct in that a lot of gold analysts have written off the referendum as unlikely in their outlook for gold prices.  He explains, however, that due to a quirk in Swiss law the public relations push for the new law, which would force the SNB to almost triple its gold reserves over five years, can be funded by anyone from anywhere.

Although Mr. Greyerz now claims that PayPal is blocking donations.

But let us not dilly-dally here when there’s obviously such a large elephant in the room.

Bears Tear Into Precious Metals Like Tin Cans

The party line has it that the US economy is recovering and no longer needs a life line from the Fed; that real bond yields will continue to rise as they did in the 1980’s (hence the strong US dollar is back); and gold prices have had their run and are about to embark on a new 20 year 1980’s style bear market.  Inflation?  What inflation.  The big threat of the day is deflation! -which is why Janet Yellen is a hero!  She must have finally defeated it.  The Grinch!  The bargains that could’ve been.

hui gold bugs indexSo when the Fed wound up its LATEST QE (asset purchase) program, the markets cheered – though not right off…not u  ntil the Bank of Japan threw its hat in the ring offering to increase its own ante in a global poker match that is setting the USD up for a smashing time in the next leg of the currency race.

But why nitpick; the economy is strong dawgawnitt.

Well, it doesn’t matter because the Bank of Japan is starting up an ENHANCED quantitative easing program designed to combat fears of deflation in Japan after a dismal GDP report (blamed largely on an increase in their VAT).  Their government pension fund meanwhile plans to double equity holdings to 50% and reduce bond holdings to 35%.

Talk about saving the day!

As soon as they caught wind of the news out of Japan, investors bought up tech and financial stocks like they were going out of style, with some believing a new perma-carry trade was just laid out – driving most of the US stock indexes back up a few percentage points to new all time highs.

Investors everywhere piled into the most expensive assets while dumping gold/silver shares –just as extra punishment for how wrong we’ve been.

Gold prices finally caved in on the low I’ve been defending for over a year (since last April), hitting a low of $1160.5 on the December comex contract.

gold spot price 31-octWho can dispute the technical significance?

In fact, gold is now just confirming what silver and the USD warned us about back in September.

So, will it fulfill its downside objective of $977?  Will silver fall to the $14 handle?  Will the DJIA mount an assault on the 20000 level?  And will the dollar recover its fallen luster as world reserve currency?

The charts have spoken.

I can’t rule out the possibility of the fulfillment of those targets.  Just about anything can happen in the short term.  What I do have conviction about is the fundamental strength of my general thesis, and that these levels offer bargains for the metals –as well as for companies in the business of finding and producing them– regardless of whether the bottom occurs here, at $1080, or all the way down to $977.

indu djia indexThe best advice I can give investors in the precious metals today is to continue to dollar cost average down in both the metals and miners, particularly those that I am picking because I am honing in on companies with the best chances of surviving this decline.  If possible, avoid margin or any leveraged producers. And keep at least 75% of your gold equity position invested in actual producers.

But, if possible, do not miss this opportunity to buy when everyone else is selling.

And, let us offer the gold bears a few things to think about before they hurt themselves.

Third Longest Bear Market in Gold Stock History

bear market legs in gold shares

We are midway through the fourth year of a bear market in precious metals shares that began shortly after April fools day in 2011.  The correction didn’t surprise us; at least not until it continued past 2012.

According to the Barron’s Gold Miners, at 43 months old we are tied with the 1939-42 bear market in gold stocks in terms of duration of the decline (average is 36) and a little below average in magnitude.

The 74% decline in the HUI would make it the second most intense decline on record but that would be an inappropriate comparison.  Unfortunately the HUI (AMEX Gold Bugs Index) didn’t exist before the 1990’s.  Nevertheless, going by the product of the two variables (i.e., duration and magnitude) this is now either the third (HUI) or fourth (BGMI) most intense bear market leg during the last ~80 years.

bear leg

Certainly it is the longest and worst downturn outside of the major gold bear market periods.

But it is probably pretty extreme even in the context of bear markets.  The worst bear market leg in history occurred at the end of the 20 year bear market cycle in gold, silver, and commodity prices from 1996 to 2000.  That’s the one that ultimately sucked me in, especially during the last leg of it.

If we were to better that decline, the current bear market would have to last another 15 months and see the Barron’s Gold Miners Index (and possibly HUI) shave off another 20-30 percent.

Now here I might interject an important difference.

The late nineties represented the end of a long bear market cycle in the metals.

If we can rule that out here, this downturn is either the beginning of a new secular bear market cycle, like the rounders at GS like to suggest, or it is just an interruption to a massive bull market in gold.

Why this is Not Your Eighties’ Bear Market (in gold)

You have heard me pontificate about the reasons that it can’t be the former – noting the historical fact that bull markets in precious metals end when the unsound monetary policy is altogether abandoned, not when amplified.  The Volcker Fed abandoned the Keynesian ideology that drove Fed policy in the sixties and seventies.  In doing so, interest rates found their market level, malinvestments liquidated, resources reallocated toward productive ends; the rot built up in previous booms was finally allowed to liquidate.  Those are the main factors that led to a somewhat sustainable financial climate for a while.

Importantly, Volcker’s policy was neither a tapering nor a typical tightening.

It was far more than that.

It was supposed to lay the foundation for revolutionary change and retrenchment in government.

Reagan and Thatcher were supposed to usher in a new era of laissez faire capitalism.

The rise in real yields under Volcker reflected this policy of allowing interest rates to find their own levels, and was therefore intense.  There are many points along that line that today’s Fed would have given in to another intervention (QE).  They were not merely ebbing or flowing.  They reflected a major change in Federal Reserve ideology…something many pundits think changes with each new head.

Unfortunately, Reagan set in motion the creation of exactly the opposite of what he campaigned.

Instead of following through with sound money and laissez faire initiatives he ramped up the war on drugs at home and expanded the state grossly.  Now we have come full circle to where governments everywhere have again adopted and implemented those formerly abandoned policies of the sixties and seventies.  Neither now nor then was the first time the ghost of Keynes had the run of the house.

The difference today though is that the situation has become critical!

One of the moral hazards resulting from the over-reliance on the policy of suppressing interest rates – all over the world – is the accumulation of levels of public debt that are unmanageable at normalized interest rates.  I’m not just pointing out the fact that the public debt is large and continues to grow.

I’m trying to elucidate the mechanism by which the government is fooling itself into accumulating more than it can handle in the long run –once economic forces take over again in the interest rate markets.

You know, when we’re all dead.

That could be true for some of us.

But this policy has been directing the rate of interest lower for decades now!

As a consequence, both interest rates and debt/gdp ratio(s) are at postwar extremes.

Thus the cost of a Volcker style abandonment of the inflationary Keynesian policy today is higher than it was in the late seventies because today normalized interest rates could bankrupt the government.

In a recent piece I showed that interest rates of around 8% could soak up to 70% of the government’s current tax revenues (good thing the Fed owns mostly the longer maturities!).

Obviously that is unsustainable even before considering the trillions in unfunded liabilities.

Yet it is irreversible given the current political climate.

The politics around this would have to change radically just to stop it -and I don’t see it.

Stopping it means public default, repudiation, or actual austerity; it means the general liquidation of government assets, massive retrenchment of the bureaucracy, privatization, sound money, and so on.

Nothing short of the total abandonment of the progressive model of government will do to achieve this.

There is of course a path of lesser resistance for those already vested in this model; that of inflating the debt away –which is really just another type of default.  In this situation the financial and economic system is destroyed.  And government may actually become an ever bigger problem in people’s lives.

My main point is that not only is the current Fed as different from the Volcker Fed as night is from day; but also, the current government cannot afford a Volcker type policy, and is unlikely to adopt one.

Consequently, since we are clearly not at the tail end of a long bear market cycle and it is unlikely that we have started a new bear market cycle (fundamentally) why not consider the possibility that it is just an interruption to the bull market.  Let’s just consider this for a moment.  Bear with me (pun intended).

Another Explanation for the Higher Volatility In This Cycle

Consider that over the course of the Fed’s history the progression of commodity cycles has become increasingly volatile.  Perhaps we can tie that to the quality of the monetary system at each stage: with the classical gold standard in the twenties still resembling something sound until it blew up, the Bretton Woods system of fixed exchange rates under the gold exchange standard a little less sound before it blew up under Nixon, and the current Friedmanite system of floating exchange rates as least sound of all…currently blowing up.  Each monetary system has involved increasing levels of centralization too.

As we move from less sound to less sound monetary standards why wouldn’t you expect volatility in the financial system to rise?  After all, look at the size of the 2001-08 rally in the BGMI above.  It is the longest one in history.  In fact, I remember selling it too soon on account of this type of analysis back in 2006.  So given these things, why would we not expect to see a bigger interruption than usual also?

And why wouldn’t we expect to see this interruption characterized by equally massive distractions in other investment trends?  That is the reason these policies are resorted to in the first place –to distract people from the unbearable truth!  It is grounded in several delusions, starting with the recovery!

The Venti Economic Delusion

Okay, so I argue that the US government can’t afford for the Fed to abandon its neo-Keynesian suppression and manipulation of interest rates, and monetarist paradigm, Volcker style today.

It has ceased purchasing US government bonds and mortgage backed securities with newly created money but it has not yet exited from its zero interest rate policy or its record long accommodation.

Nor has it started to even talk about tightening monetary policy.

This is still the craziest intervention in the Fed’s history.

And it is especially the biggest intervention (and mispricing) in interest rates probably ever.

The stuff they did in the fifties and sixties had nothing on the current Fed.

Think about the millions of dollars wasted on data and scenario modeling, luncheons, meetings, buildings, and whatever else you can think goes into “policymaking”, and the best idea they have is to hold rates too low for even longer.  What happened to the widespread criticism about Greenspan keeping short-term rates down at 1% for too long in 2003 as a leading cause of the housing bubble?

Clearly there was no consensus.

Back then the Fed dropped short term rates from 6% down to 1% between 2001 and 2003, and then started hiking them in 2004.  All throughout that period it complained how it couldn’t lower long yields.

They solved that problem this time around.

The main adjustment to that previous unsound policy was to push short term rates down to almost nothing by flooding the overnight lending markets with enough reserves to monetize a good chunk of commercial bank deposit liabilities, and long term yields down to 1%, and to maintain this for six years.

And that’s how the lessons of the last crisis were brushed under the carpet.

The official causes are a slew of incoherent rubbish, including not enough regulation, too much financial alchemy, corporate malfeasance, and of course the usual inherently unstable nature of the free market system, which is susceptible to irrational movements, and speculative booms and busts.

Just susceptible…no causes…ahem.

Well, even the veterans forget.  Even they find comfort in data points, or in their last trade.

That is just market reality; but it produces opportunity at major turning points.

For those who remember the lesson of the last crisis, the present “boom” should not surprise them.

I don’t want to bore you with too much economics but I think it is important to understand how a boom differs from economic growth in order to establish that belief in the recovery is but a popular delusion.

Unlike growth, which can only come about by saving in the real sense (abstaining from consumption) and through unhampered investment, central planners today create unsound booms by manipulating banking policy, interest rates, and money quantities.  They are unsound because they result in an imbalance between saving and investment, a build up of malinvestment, resource dislocations, and cannot last.  If they are repeated over and over again they can erode the economy’s capital base.

This is quite different than growth.

Growth is intertwined with the process of capital formation –and the broadening or lengthening of the capital structure.  The boom is hostile to capital, often resulting in its consumption or decumulation.

The policy of manipulating interest rates below market subsidizes consumption while redirecting investment (funded by “forced savings” -fancy term for money creation) into projects that can never be finished because the requisite factors of production aren’t as copious as implied in the lower rates.

The boom is the antithesis of economic growth; it isn’t merely an aid, or stimulus.

It is a tax on capital, which any economist worth his salt knows is the source of jobs and growth.

That’s why we like the slogan: “fear the boom.”

The boom feels like growth but when the policy supporting it is withdrawn the damage is revealed.

But there is more to this story…something that makes it different than any other boom.

You must understand: this is the phoniest boom ever.

Almost every other “boom” manufactured by the Fed has in the past been fueled primarily by the commercial banks as the main engines of money and credit growth.  This time around, the primary impetus behind the creation of deposit liabilities in the commercial banking system is the Fed itself!

So not only is it the greatest intervention in (“risk free”) interest rates ever – with the entire structure of asset markets keying off this for valuation – and not only is there a record quantity of investable capital being diverted into government coiffeurs – but also it is the most centrally contrived mirage of them all.

If the stock market is your economic indicator then you’re easy prey for such a devious scheme.

But again, comparable to the early eighties?  LOL.  WTF!

We are simply witnessing the force of peer pressure at work in market trends.  That’s all.

How Long Can the Boom Continue

Now that the prop (the Fed’s purchases) has disappeared the boom is running on fumes (psychology).

The commercial banks can still come to the rescue; but their participation has waned during the past two months –i.e. the growth rate in bank credit has slowed recently compared to the first half.

Alternatively, the ECB or BOJ and other central banks can ramp up their money printing.

This is the plan, I believe –if they coordinate.

But the rhetoric overseas has been ahead of its delivery.

The economic reality is that global money growth is slowing, which may undermine the boom.

Timing the bust is difficult but if none of this changes then it is a matter of months at most given the level of excess valuation in equity markets and the likelihood of a yield spike in Treasuries alone.

My aim in this section was not only to establish the delusionary nature of the growth story, or how entrenched low interest rates are in market psychology, but to highlight just how phony this boom is.

The task for policymakers here is nothing short of monumental.  They have got to take the most malinvested economy of the last 50 years, obscured by a boom that is propped up by the most interventionist monetary and fiscal policies ever, and present it to investors as the real thing.

They have to persuade investors now that the toddler can ride his bike without training wheels.

Unfortunately, the back wheel comes off with the training wheels in this case.  The rust welded them together; they’ve been on so long.  It will not be possible to avert a crash by exiting the easy policy.

This most phoniest boom of all booms is hooked on the Fed like heroin.


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(Source:  Ed Burgos:

Ed Bugos is a mining analyst, investment banking professional, and senior analyst at The Dollar Vigilante (an online guide to surviving the dollar crash), with more than 20 years experience in the investment business advising clients on portfolio and trading strategies.

Gold weighs 19.3 times as much as an equal volume of water.