Taylor on us Markets & Gold

The Paper (Financial) Markets

November 5, 2002

The Dollar Decline May be Very Significant

Technically speaking, one of the most important market developments that took place last week may have been the sudden decline in the dollar. As can be seen from the above chart, it closed at 106.08, which is not only below the 20 day, 50 day and 200 day moving average, but which has also decisively plunged below the up trend line dating back to the July-August time frame of this summer.

It may is not hard to find reasons why the dollar fell last week. There were quite a few negative headlines any one of which could have done the trick. For example:

  • The unemployment rate grew to 5.7% and payrolls declined by 5,000.
  • Consumer spending declined by 0.4%, the largest decline in 10 months.

The cutback was on bigger ticket items, most notably cars. This should not be surprising since zero interest funding programs simply moved sales ahead of schedule and was bound to result in a let down later on.

  • I didn't see anything in the press about housing but Richard Russell picked up the fact that the Mortgage Banking Association announced that mortgage demand fell a seasonally adjusted 19.3% from the prior week. Refinancing applications fell 24.1% and demand for new homes fell 6.3% to the lowest level since last April. Richard also mentioned that of the six home-building stocks he monitors, five are below their 200-day moving average. Richard concludes that the home-building stocks as a group have topped out. He further stated "We should shortly be hearing more bearish news on the housing front. This is confirmed by poor action in the numbers.
  • U.S. Manufacturing contracted for a second straight month leading to the conclusion that manufacturing is likely heading back into a recession after a brief respite into positive territory.
  • Foreclosures leap 21% in the San Francisco Bay area as the dying economy is beginning to reduce ability to service mortgage debt. (Oh! The cold winds of the signs of the Kondratieff Winter are unfortunately blowing colder!).
  • Both CFO.com and the "Financial Times" published stories about how, in spite of surging premiums, health care coverage is declining and more and more people no longer receive coverage.
  • On the investment side, the Wall Street Journal wrote a story about how mutual funds are beginning to use leverage to boost returns, thus making a major decline in fund valuations all the more likely.
  • According to the Globe and Mail, major Canadian lender, CIBC is planning to cut and halt loans to business by 1/3 to try to cut back on its corporate loan losses.
  • As sales of American auto makers decline Ford and GM are engaging in cut throat competition even as they are already losing money. Ford is planning to offer six year loans and GM is offering dealers cash incentives. And remember our discussion last week about the huge underfunded pensions for the automakers?
  • Merrill Lynch recently reported that 98% of the S&P 500 companies have underfunded pension programs. Those pensions will have to be funded from future cash flows which will put downward pressure on future earnings, unless an extremely overvalued stock market somehow resume a bull market.

In other words, the American economy and indeed the global economy seems to be in big trouble. And I would argue, as a deflationist, that perhaps the most significant headline above was that of CIBC cutting back on its lending policies. Indeed, this is at the very heart of the deflationary depression argument. When banks cut back on lending, the money supply stops growing. More on the deflation/inflation issue below.

Only a Select Few See the Big Picture

What seems to be most problematic is that very few policy makers are focused on the big picture. All of these high priced economists, politicians and Wall Street sales people look at one stat at a time and fail to see pathological economic imbalances and relationships in the global economy as a whole. One of the few major main steam name economists who does seem to see the bigger picture is Stephen Roach, Chief Economist at Morgan Stanley. He is terribly worried about the global dependence on the U.S. to continue to weaken its collective balance sheet to buy the world's goods and services. And he alone among major economists have begun to talk about the views expressed by Dr. John Whitney (CEO of Itronics, Inc. & CEO of mine engineering firm of Whitney & Whitney) namely that the U.S. dollar is grossly overvalued and an that equally undervalued Chinese currency is playing a major role in what Roach calls the "U.S. centric" global economic imbalance that is leading the global economy down a path of utter ruin.

Yet Wall Street fights hard to maintain the dishonest strong dollar policy. The strong dollar allows the Wall Street to keep the stock market up and to suck more money into the market, so the insiders can get out while the getting is still possible. And it allows Americans to keep buying cheap goods and services even as America slides deeper and deeper into a bankrupt country. So, Wall Street hangs on to the dollar lie and our policy makers continue to trash the gold price with the increasingly desperate hope that somehow an already grossly overvalued stock market can return to the good old days. Again, Dr. Roach is about the only main stream economist in America I can think of who sees the emerging cataclysmic global picture which he described last week in his October 28th essay as "A Collision of Forces."

The Inflation/Deflation Debate Gets Hotter

I began to buy into the deflation argument back in 1999 after interviewing Ian Gordon. (See miningstocks.com to read our initial interview and an update). Actually in the early 1980's I became familiar with the deflationary argument of John Exter through his disciples Ron Gilchrist (one of our favorite stock brokers) and Barry Downs, another stockbroker, who married John Exter's daughter. (Barry is currently the President of a newly formed gold royalty company on our list named American International Ventures ( OTC BB -AIVN-$0.25). I still believe deflation and not inflation will be the near term curse of America and indeed the global economy for reasons is frequently discuss in my weekly reports. Again, the major reasons I believe in deflation are the following:

  • Mal investment that resulted from the phony creation of money for political aims and to accommodate theft by the banking system.
  • The exponential rise in debt from which the exponential rise in money was created.
  • Declining cash flows resulting from mal investment.
  • Decreasing demand for goods and services in the economy as a result of larger amounts of cash flow extracted out of the economy to servicing debt.
  • A global economy that represents the antithesis of free trade thanks to a rigged currency scheme that completely distorts purchasing power parity. This has allowed certain countries, most notably China to have an unfair trade advantage against American manufacturing, agriculture and mining concerns. No one can or should complain about fair competition. Everyone benefits from that. But with currencies having nothing to do with purchasing power parity, the current system in careening out of control with cheap goods from China and other developing countries.
  • Declining corporate profits as a result of the aforementioned unfair advantage that China and other developing countries enjoy over the U.S. With lower profits, capital expenditures are falling sharply and unemployment is rising which in turn reduces disposable income and hence further reduces aggregate economic demand.

Several essays on both sides of the deflation/inflation argument have been circulating over the past couple of weeks. I would love to delve into these in great detail, but I simply do not have the time and these weekly messages are already way too long. So let me try to summarize the inflationary argument and say why I do not agree.

Inflationary argument #1 Deflation by definition requires a reduction in the money supply. We do not have deflation because the money supply is still expanding. Response: The money supply has been increasing at a torrid pace over the past year. But in spite of that, the rate of inflation has been decreasing. Moreover, repeated attempts to revive a sagging U.S. economy with monetary stimulus has not only failed the revive the economy. It has also failed to revive the stock market which for the first time since the 1930's has declined after one year following rate cuts.

Inflationary Argument #2. The only way the money supply can decrease and hence deflation to take place is if the banks begin to fail and depositors begin to lose the money they deposited with the banks. The U.S. has FDIC insurance in place which insures deposits up to $100,000, thus providing confidence to investors that they will always have their money returned to them. The idea here is that government can simply print more money if it needs to pay for any losses that result from a bank failure. Response: Deposit insurance is no guarantee that the banking system will remain healthy. In fact, I would argue just the opposite is true because as I pointed out last week, deposit insurance leads to bad lending decisions on the part of banks which in turn leads to mal investment in the economy which in turn results in declining GDP. One need only look at Japan to see this is true. Japan had even more complete insurance coverage for its depositors than the U.S. and its system is failing in no small part as a result of that excessive money creation over a long period of time. And now the Japanese are faced with the need to either pull the plug on the banking system, causing it to collapse or continue to wallow in the same deflationary policies they wallowed in for the past ten years. Indeed, Japan is a case in point that demonstrates deflation does not necessarily need to result from a declining money supply. The money supply in Japan has grown rapidly even as the economy has remained in decline.

Inflation Argument # 3. One proponent of inflation argued that we had only to compare the U.S. economy with Argentina to see that inflation is inevitable. It is my view that no country in the world can be compared to the U.S. because the U.S. currency is by itself the dominant global currency. I do accept the idea that the U.S. could generate inflation if it simply and literally began printing money without making corresponding liability entries on the books of its banking system. Simply print and then shower millions of hundred dollar bills on America from airplanes and you would get inflation. Of that I have no doubt. But if the U.S. were to do that, the U.S. dollar would immediately be trashed as huge foreign investors in the U.S. would run out of the currency. At that point, not only inflation, but hyper inflation would be the likely outcome. Argentina can do that. The U.S. cannot. So until the system self destructs and the dollar is no longer welcomed as the world's reserve currency, the U.S. will be confined to the deflationary constraints of creating money through the issuance debt, which as we have pointed out is exactly the poison that is sucking our country into a deflationary quicksand.

At such a time as the U.S. dollar is utterly trashed and as a result freed from its burden (and benefits) of being the world's reserve currency, I agree that the dollar could be inflated. But as Ian Gordon has pointed out so well, at the point where the Kondratieff Autumn ends, debt has built up to such enormous levels that there is no solution other than a deflationary collapse and debt repudiation through massive bankruptcies. Only when this happens will the Kondratieff winter season end, thus preparing us for the Kondratieff spring and the next long wave. What needs to be pointed out is that the debt repudiation period, painful as it is, represents a process where economic and monetary distortions arise from abusive monetary policies are set straight via bankruptcy and debt repudiation. Thereafter the slate is wiped clean and new cycle is set to begin. Would that humans would learn to reduce intervention, these cycles would be much more tame. But rather than reducing intervention, we see the trend toward greater intervention. Thus thanks the creation of the Fed, the 1930's was the worst depression in American history and the one that is now staring us in the face is likely to be worse than that of the 1930's.

The notion that the Fed can't do anything to override deflationary dynamics that are now being played out globally is alien not only to Keynesians but also to most of my friends who identify more with the Austrian school of economics, most of whom can only envision inflation. Yet, history clearly shows that both fiscal and monetary stimulus was tried and failed to curtail the Great Depression in the U.S. Likewise, for those who think deposit insurance can save the banking system, one need only look at the current Japanese example. Deposit insurance may have allowed a sick system to live a longer life, but the Japanese patient continues to become weaker in no small part BECAUSE of deposit insurance which limits the discipline of sound lending policies by the banks. Hence the banks become unable to lend and thus stimulate the Japanese economy.


Technically the gold market is looking very strong at the end of this week. The Highly regarded Carl Swenlin at www.decisionpoint.com said the following with respect to gold toward the end of last week:

OUTLOOK for GOLD: BULLISH as of 10/31/2002 (Gold was 317.60).

"Gold looks constructive in all time frames. The most positive recent event affecting gold is the breakdown of the Dollar Index. While I don't think gold has responded as positively as it ought to have done, the slide of the dollar only serves to support the price of gold. Consequently, I have changed from NEUTRAL to BULLISH on gold."

More and More Countries are Accommodating Gold Trading

One of the factors that I have noticed recently is constant flow of pro gold programs cropping up in various other nations. China now has a gold exchange. India has been rumored to be getting ready to launch a gold coin that would be used as currency and the country is also talking of allowing futures trading to take place in gold. Sometime ago, Russia made a move toward monetizing gold. And recently, we have heard that various countries are indeed coming together to make the gold Dinar a reality, at least in terms of using that unit of currency for trade amongst the Islamic countries. Indeed, as James Sinclair opined this past week that he thinks this is a very significant development and that these countries are very serious about switching from dollar to gold as a medium of exchange. This in fact will represent a snubbing of the IMF, which forbids member countries to use gold as money. If/when the U.S. goes to war against Iraq, the desire to trash the U.S. dollar in favor of gold could well intensify.

As a Christian, I have no interest whatsoever in seeing the Islamic world triumph in any way over the West. However, I do believe that the West is sewing the seeds of its own destruction through its increasing immoral lifestyle and dishonesty. And as Professor Payton Yoder told my history class in 1966, very much a part of a nation's declining morals is a debased currency. Fiat money is theft. It grants the right to the privileged few elite bankers to create claims against the wealth of a nation that they had little or nothing to do with the creation of wealth. And when massive amounts of money is pumped into the system as Mr. Greenspan has done especially from the mid 1990's onward, a false sense of values are encouraged such that people find all sorts of devious ways to become rich while forgetting to do an honest days work. This is especially true of those who work closes to the money center bankers who are at the heart of this scheme which is nothing less than legalized counterfeit. In addition, people become insensitive to the reality of debt so they take on more and more if it until one by one and than en mass the nation's economic life is chocked away.

Promoting Gold as Jewelry is a Waste of Time & Shareholder Money

Dr. Larry Parks wrote a very revealing article titled The Near Death and Resurrection of the Gold Mining Industry that appeared in the July 18, 2000 issue of J Taylor's Gold & Technology Stocks newsletter. Larry's article explains how and why the hundreds of millions of dollars channeled to the World Gold Council at the expense of gold mining company shareholders has been wasted. You can read Larry's article at www.miningstocks.com. Click on "Read other Interviews" on the Home page of this site and then click on the article's title but we will try to summarize as best the arguments made by Dr. Parks. In his article, he demonstrates that the strategy of the World Gold Council to promote gold as jewelry is definitely a losing proposition for mining companies. It may be good for jewelry manufacturers who want to see the price of gold lower, but that is hardly helpful to companies that produce gold thus SHOULD want to see the price of gold higher.

We don't want to be too hard on most folks who assume the World Gold Council has its client's best interest at heart. After all, it seems logical enough to assume that if the World Gold Council can get people to buy more jewelry, the price of gold would rise. But in fact the data suggest exactly the opposite is true.

The next two charts provided by Dr. Parks demonstrate that high gold prices are incompatible with rising demand from jewelry manufacturers.

Chart 1: Jewelry gold offtake for the years 1972 -1999 vs. the price of gold (source: Tonnage gold used for jewelry fabrication from Gold Fields Mineral Survey; Price data from Kitco www.kitco.com).

Chart 2: Correlation between the price of gold and jewelry gold offtake for the years 1987 (the year the World Gold Council began operation) and 1999. Data sources: jewelry fabrication from Gold Fields Mineral Services; Gold Price data from Kitco.

Dr. Parks wrote, " While correlation does not prove causation, it is noteworthy that since 1987 jewelry offtake and the price of gold have had consistent and significant negative correlations. The data indicate that for more than fourteen years, whenever the price of gold decreased, jewelry offtake increased, and vice versa. Either way, especially in light of these high negative correlations, the clear implication is that promoting gold jewelry will not be profitable for the producers. Mindful of this evidence, why does anyone believe that further increases in jewelry offtake will reverse a relationship that has held for almost two decades?"

Jewelry is a low-value marginal use for gold Dr. Parks then made an interesting comparison between gold and Perrier Water, writing, "The above data suggest that jewelry is a low-value/low-utility marginal market for gold, albeit one that can, as the price decreases, suck up an unlimited amount of gold. It's as if Perrier Water was diverted from its primary high-value/high-utility market as drinking water to a much lower-value/low-utility market, such as crop irrigation. It's not worth $2 a bottle, or even five cents per bottle, to water crops.

"When the gold price is perceived as cheap, more of it is fabricated into jewelry. If gold demand for a higher-value use increases, then the gold price increases, and gold demand for jewelry fabrication falls off. In other words, jewelry fabricators are akin to marginal salvagers; they use more gold when the price decreases. By promoting gold jewelry, the producers have diverted gold from a higher-value use to a much lower-value use. This is confirmed by the empirical data.

Understanding the evidence

"The most important insight to be gained from this data is that a decrease in jewelry offtake coincides with an increase in the price of gold. Any increase in the price of gold means that there must have been increased demand. The use of gold to which that increased demand was put, therefore, must have a higher value to whomever bought the gold than to those who buy gold for jewelry fabrication.

"Whatever the higher-value use of gold is, that is the market the producers should concentrate on; not jewelry fabrication, which, as the data confirms, is a lower-value use. The evidence (Chart 3) shows that large increases in inflation correspond with a higher gold price. Gold used for jewelry fabrication has nothing to do with the result.

Chart 3: Gold Price vs. % changes in the Consumer Price Index (CPI) for the years 1971 to 1999. Data Source: Gold prices from Kitco; CPI data from the Federal Reserve of St. Louis. Series ID: CUUR0000AA0, Not Seasonally Adjusted, Area: U.S. city average, Item: All items - old base, Base Period: 1967=100. The next chart clearly shows that as the rate of inflation (CPI) rises so does the price of gold. The chart also shows that even in low inflation periods, the price of gold is positively correlated with the rate of inflation.

Chart 4: Correlation between the price of gold and percent the Consumer Price Index for the years 1972 to 1999. Data Source: Gold prices from Kitco; CPI data from the Federal Reserve of St. Louis. Series ID: CUUR0000AA0, Not Seasonally Adjusted, Area: U.S. city average, Item: All items - old base, Base Period: 1967=100.

In effect, as people lose confidence in fiat money, they look for money that will retain its value. As the chart above demonstrates, during the 1970's, confidence was undermined by its eroding purchasing power evidenced by inflation. So, as the rate of inflation rose, the price of gold rose. And interestingly too, as the price of gold rose, the demand for gold as money also increased. In other words, when people look to gold as money, the higher the price of gold rises, demand increases not decreases as is true for gold used as jewelry. Your editor also argues that during deflationary periods of time, gold also is highly in demand because, in the midst of deflation, especially when debt levels are exceedingly high, people become concerned about the stability of their banking system at which time gold also rises. This is exactly what has been happening in Japan. Debt is on the rise and so too is demand for gold because the Japanese people are not sure their money will be available to them when they need it.

Gold is uniquely suited among the metals to serve as money. If that were not true, there would not be so much of it laying around in vaults. Dr. Parks once told me that there is something like a 40-year supply of above ground gold. That in itself proves that gold is money, whether central banks, politicians and fiat money scam artists of all stripes like it or not. What reason other than to serve as a monetary reserve would so much gold exist? Supplies of other hard commodities usually are adequate to meet supply the markets from several months to one or two years because other metals are produced only to meet consumption demand rather than monetary demand.

The Federal Reserve Bank of New York holds the world's largest accumulation of monetary gold.

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