Economist Henry Hazlitt, former Wall Street Journal reporter and “founding board member” of the Mises institute, wrote in the late 1960’s: “What we commonly find, in going through the histories of substantial or prolonged inflations in various countries, is that, in the early stages, prices rise by less than the increase in the quantity of money; that in the middle stages they may rise in rough proportion to the increase in the quantity of money (after making due allowance for changes that may also occur in the supply of goods); but that, when an inflation has been prolonged beyond a certain point, or has shown signs of acceleration, prices rise by more than the increase in the quantity of money… As a result, the larger supply of money actually has a smaller total purchasing power than the previous lower supply of money. There are, therefore, paradoxically, complaints of a ‘shortage of money’.”
What he was saying is that early in the inflation, the value of money does not drop as much because the individuals determining its value are used to it having a stable purchasing power. Expectations, however, will change as the inflation progresses, and eventually the value of money drops faster…
That is how, yielding to cries for more money and credit, the dog chases its tail right into hyperinflation.
The bull market in gold started on a transition to “the middle stages” of an inflation cycle that began with Greenspan’s reign in the nineties. During that decade, the pundits argued that inflation was dead and that there was no longer any correlation between money supply growth and the price level, which was true if you forgave the method of calculation of both statistics, and ignored the technology bubble.
But, the fact was simply that we were in “the early stages” of a new inflation cycle.
The last one ended with Paul Volcker, Greenspan’s predecessor. Volcker had resolve, but that’s not saying much because America’s policymakers had nothing left to lose by 1978. Attempts to lower the long-term bond yield failed through the seventies as it went to higher highs whenever the Fed stopped lowering short-term yields. By the time Volcker got in, the economy suffered almost a decade of rising prices and interest rates, the stock market was trading at less than 10 times earnings, the dollar made new record lows, there were long lines at the gas stations, and the banks (to buy gold), and the policy of expanding money (inflation) was no longer boosting employment or growth… and then, stagflation!
Only then did the central bank and government deal directly with the root cause of the problem.
They face too much risk today for that kind of resolve. The stock market is trading at about 20 times earnings and bond yields are in the low single digits. People are only beginning to see that inflation is not quite dead. They are not yet demanding higher wages and pushing up interest rates because of it, at least not widely. It is not yet causing unemployment. The inflation policy is still a useful tool for the expropriation of wealth under the guise of illusory booms. It is not yet producing results that will make it unpopular. If it was abandoned now, the detrimental effects would be great. They cannot afford it.
Naturally, this predicament all but guarantees the later stages of inflation, where “prices rise by more than the increase in the quantity of money” as people lose confidence in the value of money.
From there we get the combination of rising prices and recession that people who can’t recognize the early stages of hyperinflation will call stagflation. I don’t think we’ll see that until the next recession, and if central bankers or politicians continue to bury their collective heads in the sand then, you’ll see the “crack up boom,” a term that readers of this publication are no doubt familiar with by now.
So it is that the current environment for gold couldn’t be better. You have the Federal Reserve System slashing rates aggressively and leaning on depression era loopholes in order to stave off a financial crisis, which it caused by slashing rates and expanding credit too aggressively in the first place.
And it is doing it at a time when commodity prices are printing records that the pundits never imagined possible a decade ago, and when even the massaged inflation numbers are approaching the high end of a two-decade range! Combined with the bail out package offered by the government, where’s the discipline that will deter the reckless lending tomorrow? If you understand recessions as corrections to natural market ratios, these moves will only continue to underwrite poor quality economic booms.
We are seeing the Federal Reserve make history by expanding its reach past the government T-bill market into the mortgage and brokerage businesses, which will only help it generate more inflation more directly in the future. You have a free-falling currency that can’t seem to find a floor against other fiat never mind gold, national default rates running at a record pace, supply side shortages in gold caused by socialistic policies and resource constraints in some parts of the world, and so on.
You can add the fact that production costs in the gold business as well as MZM, the broadest measure of U.S. “liquidity”, have both doubled since the bull market in gold began – raising the floor substantially.
So then, what triggered this gold correction?
The latest advance in gold kicked off with the spreading of the subprime crisis in the final months of summer 2007. The crisis has not likely peaked. Citigroup is predicting way more rate cuts ahead.
Why would a gold correction of any magnitude begin on the week that one of the largest brokers in the world blew up, especially when followed by the kind of policies that should have fired gold right up?
Was it a “sell the news” phenomenon? Maybe, but that would definitely mean buy this dip now.
Last week, the market expected the Federal Open Market Committee to cut its fed funds rate by a full percentage point, but it disappointed the market by cutting only three quarters of a point – on account that it was worried about inflation. The sentiment produced the best of all worlds: soaring stock prices and falling commodity prices, as if such a deep rate cut could actually boost growth and quell inflation all in one fell swoop.
C’mon. How’s that again? That’s right. The press told us the Fed was worried about stoking inflation expectations, so it held back the extra one-quarter of a percentage point.
Heck, it only needed to recognize that most of the leverage was concentrated on the bullish side of the commodity markets. By upsetting market expectations, this is where it would hurt the most. Add a conveniently timed rumor that the futures exchanges may lift margin requirements, and news that the Chinese had raised their reserve requirements, again, the catalysts for the correction becomes clear.
It’s one of the main reasons I don’t believe this correction. Most commodities are due for a correction of some magnitude, and that the dollar is due for a meaningful bear market rally, and that these things are going to cause choppy trade in gold. But gold should be able to decouple from those correlations as the market realizes that the bull market in commodities is about money, and that the dollar is not the only inflationary currency.
This advance in gold will continue without a serious interruption until either it is allowed to blow off on its own into an unsustainable froth, or the Federal Reserve targets inflation – by raising real interest rates (past neutral), or reserve requirements, or some form of credit tightening.
It does not have this resolve today, clearly.
Corrections are healthy. By all counts, one was due in gold anyway. The market was getting a little too far away from its 40-day moving average, and exhausted the $950 implied objective of last year’s breakout weeks ago. If you are expecting the current leg to outperform the 2005-06 rally, as I am, you were/are expecting gold prices to make it past the $1100 level before experiencing an intermediate correction of the sort we saw in 2006 – 27% from peak to trough and lasting six to twelve months.
The current correction has been half that depth so far. There are similarities. But it has not triggered any real intermediate sell signals in my model. The bullish case for a climax at $1200 plus (before this summer) is not yet injured on the chart – so long as the bulls hold the line at between $850 and $900.
The last highest low in the intermediate (7-month rally) sequence is at $885 in the cash market. The market could just be making some elbow room for a lunge higher.
It could consolidate for a few weeks yet, as the Dow tests the parameters of its newly forming bearish trend. That conviction is young itself, and it is having trouble engaging because the Fed is fighting that trend. A rally in stock markets engendered by the Fed’s rate cuts could alone reignite concerns about inflation, but if not, if it starts to fail, I expect gold will be ready to begin move to my $1200-1400 target.
And it could all happen in months.
Unlike the base and other precious metals, oil, and almost any other commodity, gold has not yet seen the kind of upside volatility that would force me to call a correction beyond what is considered normal.
Unfortunately, the situation is more tentative for gold share investors. A bear market on Wall Street means rising risk premiums and contracting value multiples, and gold stocks are not cheap. Mining companies are not immune to the effects of rising costs on production and development. They are businesses. And as shares, they are not immune to rising bond yields.
Bond yields are not rising right now, but they will. It’s difficult to find values in the gold share sector today, at least at the mid to large cap levels. Consequently, I believe they will have difficulty keeping up with gold, especially if stocks are falling.
On the other hand, I’m finding many values in the juniors and small caps, many of which have been in decline since the 2006 peak in gold – and that have sat out the entire 400 dollar rally since August.
In some cases, the decline is warranted as they went to absurd values in the 2003-2006 period. In other cases the decline has left many juniors trading at or near their cash break up values.
The obvious point is that the seven month old gold rally has not reinvigorated much froth broadly. And the risk/reward ratio now favors the juniors, though because they are risk assets there is the chance that they could fall further if the general stock market environment continues to deteriorate.
My advice is to continue to generally overweight gold directly (physical or ETF), reduce or hedge your positions in the expensive mid to large cap precious metals producers, sell all your non-precious metal resource shares, and accumulate the best quality junior gold, silver and platinum assets from here on.
for The Daily Reckoning Australia