The Bedrock Case for the Return of the Gold Bull

Earlier this week we talked about why gold got crushed.

In response to that piece, some of you felt the Russia-Georgia conflict was more of a “post-mortem” than a true explanation. Taipan Daily reader Luis from Mexico writes, “I would appreciate a more technical view of gold's valuation, since it has some predictive power.”

Luis, your wish is my command... but with a slight twist. Take a look at this recent chart of GDX, the Market Vectors Gold Miners ETF.

click to enlarge

Notice the volume bars at the bottom of the chart. See that huge spike on Monday the 11th? The one that nearly touches the 10-million-share mark? You don’t have to squint to spot it -- it’s easily the biggest spike of the year.

What you’re seeing there is major capitulation... traders throwing in the towel big time on gold mining stocks. I focused on the Russia-Georgia conflict earlier this week because it was such a key emotional factor.

The fundamental backdrop for commodities and precious metals was already tough, with the dollar going up and raw materials going down. On this GDX chart, we can see how short-term pessimism led to an avalanche of selling.

As a technical rule of thumb, major volume spikes tend to mark the beginning and ending of moves. The reason why is pretty straightforward: A big down day on big volume clears the “weak hands” from the marketplace. After a mass rush to the exits, most everyone who wants to sell has already sold.

The reverse logic applies on the upside. After a huge up day with volume to match, most traders looking to buy have already bought. The combination of volume and volatility can reveal a lot -- not because of some special magic in the chart pattern, but because these factors sit at the intersection of sentiment, supply and demand.

The sentiment in gold and gold stocks is bad right now, but I have to admit... I like that washout pattern in GDX. With most of the nervous Nelly sellers now done, having panicked to the sidelines on Monday, the decks are cleared for a strong move higher when GDX starts acting right again.

The von Mises Prophecy

But what I really want to talk about today is the “bedrock” case for gold... the reason why I have every confidence the yellow metal will rise again.

I have to confess, though, for longtime readers, the argument I’m about to present isn’t new. I’ve been saying it for years now. It’s been true since time immemorial, and nothing has changed.

Rather than repeat myself yet again, I’ll indulge in the luxury of quoting myself (if you don’t mind). Below is an excerpt from a piece I co-wrote with Sally Limantour earlier this year:

Ludwig von Mises, the father of Austrian economics, recognized early on that government attempts to massage the credit cycle always end in tears. The problem is that no politician wants an economic downturn to take place on his or her watch; so why let it happen when a little stimulus can keep the party going? A little stimulus becomes a little more, and then a little more, and next thing you know, addiction sets in.

Business downturns are natural things for a healthy economy. They are the economic equivalent of breathing in and out. In a normal downturn, debt levels are cut back, weak businesses close, resources are gathered up and redistributed, and the economy overall takes time to heal and restrengthen.

When this process isn’t allowed to happen, however, the shaky parts of the economy get built up too much. Expansion ceases to be healthy. Ongoing stimulus leads to excessive debt creation, the debt builds up to unsustainable levels, and eventually the whole shebang implodes on someone else’s watch. Von Mises memorably described the phenomenon as follows:

"There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

The “final and total catastrophe of the currency system” -- in this case the U.S. dollar -- is what we are headed for. It isn’t all Bernanke’s fault, though. Bernanke simply inherited this mess from Alan Greenspan. We are not just heading into the endgame for a short-term boom-and-bust cycle, but rather a much longer borrow-and-spend cycle that took root early in Greenspan’s tenure.

Who Ya Gonna Believe?

In a nutshell, gold is not done because the great unwinding is far from done. We have not yet seen “the final collapse of a boom expansion brought about by credit expansion” that von Mises called for.

With all the idiocy Wall Street has thrown at us these past two years, hopefully the last efficient market theorist has closed up shop and turned out the lights. Stock markets are decidedly not efficient. (One could say they are mostly efficient, but that’s a whole other kettle of fish.)

And so, when investors and traders get emotional, they tend to get really emotional... and when a big hope jag or a really dumb idea gets in the crowd’s collective head, that statement goes double.

Take a look at this dollar chart to see what I mean…

What I’m arguing here is that the dollar’s giant spike over the past two weeks -- and gold’s corresponding fall -- are a sort of faulty “all clear” signal. With oil and gold falling and the dollar spiking, Wall Street is indulging itself in the hope that the worst has passed. Good times are here again.

It’s a massive hope jag... a bold assertion that von Mises was wrong, that the dollar won’t be destroyed, that all will be well and the Fed has won the war.

But here’s why I have trouble with that hope jag:

• The folks who predicted the credit crunch would happen -- the analysts and forecasters and traders who got it right -- are still expecting more pain to come.
• The Pollyanna types who think the worst is over, in contrast, have already said “the worst is over” multiple times... and they’ve been wrong all along! (So what gives them odds on being right now?)

On the one hand, you have the views of forecasters like Meredith Whitney and Nouriel Roubini. Both were very early, very bearish and very right. Both are expecting a lot more pain to come, with the likelihood that consumers will be further crunched and hundreds of banks could fail.

On the other hand, you have guys like Bill Miller, the mutual fund demigod who fell hard from grace. Not only was Miller aggressively long and wrong the whole way down, losing billions for his investors on bad bets in financials and homebuilders, he is still doubling down on his blown-out financial positions. (Legg Mason is now Freddie Mac’s top shareholder.)

To believe that gold is done here is to believe that the worst is over... that the excesses have all been unwound, that the central banks have triumphed, that paper currencies have won the day. That proposition just seems like utter goofiness to me.

The dangers surround us. We are only two years out from a time when America’s savings rate went negative (for the first time since the Great Depression). We have only just begun to feel the effects of consumer belt tightening. There is clear evidence that “subprime” woes are spreading to “prime.” GM, Ford and Chrysler are still on a path to a disaster. More bailouts loom.

A Central Banker’s Worst Nightmare

There are some who agree that the U.S. is in for more economic pain but stay bearish on gold anyway because of deflation fears.

That argument goes something like this: “Because we are headed for global slowdown -- with Europe maybe worse off than the US -- we’re going to see inflation slow down, too. All the consumer belt tightening and economic malaise and so on will translate to falling prices... which means no inflation fears and no need for gold.”

I can respect this line of thought. It make sense to assume that prices will fall in the event of global slowdown. And we’re seeing evidence of this, too. According to Bloomberg, the Baltic Dry Index, a benchmark for shipping costs, has fallen for 23 consecutive sessions.

“What we have is a classic cyclical downturn,” says Andreas Vergottis of Tufton Oceanic Ltd. “People are not buying cars and people are not buying houses, and when that stops, it travels backwards all the way back to the mine.”

But those who expect falling prices to rule the day are forgetting something very important: In a paper currency world, the central banks build their reputation as inflation fighters. But when it comes to economic devastation, deflation is the real bogeyman.

When prices start to fall in earnest, consumers get scared and start cutting back on all their purchases. This in turn causes prices to fall further as sales dry up and business profits fall. A fall in profits causes more people to lose their jobs, which in turn causes more fear to set in, and the cycle deepens.

This is known as a “liquidity trap,” leading to conditions where the central bank finds itself “pushing on a string.” When the deflationary spiral gets bad enough, extra stimulus fails to have any effect. The Fed becomes like a credit card lender trying to help a debt addict who just can’t borrow anymore.

Deflation Begets Inflation

Fed Chairman Ben Bernanke will never let the above scenario happen. He is, literally, a student of the Great Depression. Studying the Great Depression, and coming up with ways to prevent its reoccurrence, is in large part Bernanke’s lifework.

This is why deflation will ultimately beget inflation... it will come by way of the printing press.

The greater the leverage in the system, the greater the risk a deflationary downward spiral poses. No central banker worth his salt will ignore that risk.

A healthy economy -- that is to say, one that isn’t loaded to the gills with debt -- has no problem handling a mild downturn. Like a healthy human body, a healthy economy has reserves of strength to handle sickness and facilitate the healing process.

But a badly weakened economy -- one that labors under a crushing burden of debt -- will have trouble handling even a mild illness. The reserves of strength are already used up. By way of this analogy, the Fed is like a doctor who has no choice but to intervene with massive doses of drugs. If the patient is going to die of fever, then even the most radical course of action is preferable to doing nothing.

A Window That Will Close

As far as gold goes, I believe we’re in the midst of a short-term “sigh of relief” window right now... and it’s a window that will close. The dollar may be rallying hard now, but the von Mises prophecy still applies. The situation on the ground hasn’t changed.

On the currency side of things, gold’s fortunes will change when traders realize that all paper currencies are headed for oblivion.

For a while there the euro was king of the hill while the dollar was being beaten down. Now that the world is waking up to Europe’s slowdown, the euro is getting trashed while the greenback gets a boost. But guess what... All over the world, the bankers’ reaction to the threat of slowdown is the same: Print more money. Slash interest rates. Find ways to stimulate. Pump more money into the system.

As others before me have so eloquently put it, gold is the only currency not subject to a printing press. When the complacency window shuts, traders and investors will realize anew just how important that is. If inflation continues to march higher, so will gold. If deflation catches the world in a vice grip, gold will skyrocket relative to fiat alternatives as all paper currencies get debased.

Comments

[ZgartZ]

Excellent report. Thanks.
Here in Florida, I see a noticeable increase in traffic on Hwy US41 this weekend. It doesn't take long for the public to feel good when gas drops to ONLY $3.68 a gallon. Ha! Little do they know that $5.00 a gallon is in the cards.

[phillips49]

The is no arguement that the US financial system is stressed. However, this does not mean that gold is a safe haven either. There are those that would say, it's different this time, but looking at the history of gold prices though booms and busts over the last 30 years, gold is a lousy investment and certainly not a hedge against inflation. Gold was flat from 1981 to the end of 2004. (23 very long years) It lost ground against inflation all during that time. If you bought gold at $400/oz in 1981, then to have just even purchasing parity today, gold would have to be $1,150/oz. In 2005, gold began to climb. So what happened ?....A period of enlightenment? ....No, actually, the introduction of gold ETF's happened in the 4th quarter of 2004. Everyman suddenly had access to gold if they wanted to play. The ETF itself actually created an artificial demand for the metal that wasn't there before. The current price is sustainable only if sellers don't out number buyers. In other words you are dependent on the guy next to you to hold and not sell. Until of course you get scared and decide to sell yours first. Investors have been fleeing all asset classes, including gold.
It is also a mistake to liken gold to currency. The governments of the world won't let that happen. And they will conspire together to make sure it doesn't happen. Gold will never be accpted as legal tender in the grocery store. It will always have to be converted into paper. They own enough gold, that if even partially sold, would drop the price of gold into the last century. If you bought a 1000 shares of GLD, this summer when the hype was high, say at $90.00, then you're out a lot of money in a very short period of time. What has inflation done in the last one month? It sure didn't rise 14%. I'm not anti gold or a nay sayer. It just is what it is!

[buyitcheaper]

Over a typical interest rate cycle, gold will retain its purchasing power and is convertible to legal tender. so that is specious. And anyone who would buy GLD or any other equity without a stop, deserves to lose their money. So again, somewhat specious.

Inflation doesn't rise 14% in amonth, it rises 0.09% a month, every month, for two or three years, and then you look back and that same suit that cost you $500, now costs you $950. That $1.29 dozen eggs costs $3.99 (CLM a recommendation there.)

Also, you will see beef inflating significantly this fall as the early culling due to grains incredible rise forced beef producers to push their product to market much earlier which will result in a scarcity of supply this fall. This will make support the higher overall inflation numbers which is ultimately why gold will start tracking back up toward the end of the year absent a SERIOUS intervention by the Fed, i..e a real interest rate increase of 1% point or more.

Does anyone have Volcker's number?

[CLH]

Phillips---You are right on target. The writer of the above post --Litle is in denial.

[jakedeez]

I still don't get what the point of owning gold in an investment account is... A trade maybe, but to own it? Why?

[DenisL]

Gold is a disaster hedge...not an investment.
It is for times of war, hyperinflation, banks failing and governments going crazy with spending. It is NOT an inflation hedge unless it is hyperinflation.

I still think we are in for some VERY rough economic water (at least another $1 trillion dollar loss in the housing markets) AND the powers that be will need a WAR to distract the masses from the economic problems/fallout. Before then we WILL see some price deflation. Hang on to your gold if you can not time this. Sell your gold if YOU can predict WHEN the next disaster will hit. In ANY case with the current folks in charge it is silly NOT to have at least 10% of your assets in gold at ALL times, more if you think, as I do, that disaster is looming. Deflation in housing prices WILL not help the heavily leveraged financial markets AND no one is predicting a rise in housing prices until late 2009 or early 2010, the housing bubble is still popping even if there is inflation in other areas. I think that one could sell gold now IF you believe we will NOT be in a WAR in the next year. AND then buy it back again once the gold bubble has popped. I do not have that kind of nerve. I will hold on to gold AND sleep better at night.

[rawprawn]

"When prices start to fall in earnest, consumers get scared and star cutting back on all their purchases". This is a denial of fundamental supply/demand economics. If this is the basis of deflation theory, could someone explain the above paradox?

[ozzy43]

"Gold will never be accepted as legal tender in the grocery store. It will always have to be converted into paper."

Tell that to the folks in Zimbabwe. The whole point here is that, when legal tender becomes worthless (wheelbarrows full), there will be plenty of folks willing to accept something of REAL value - gold, silver, and the like - in exchange for what they're trying to sell. At least, that's precisely what's happened the other gazillion times in history that fiat currencies have imploded, from 11th century China to 18th century France to 19th century America (ever heard of the Continental?) to 20th century Germany. Of course the poster who wrote the above may be right - maybe we are just so amazingly smart and special, we 21st century humans, with our central banks which simultaneously create AND fight inflation (neat trick, that), that for the very first time in thousands of years of recorded history, a fiat currency in the hands of a reckless government will not wind up causing a hyperinflationary environment to ensue engendering a collapse of the monetary system and a flight to whatever people perceive as 'things that hold value', with gold having historically topped the list.

Yeah. I'll expect that to happen just as soon as politicians learn to tell the truth.

[ozzy43]

rawprawn I am not sure, but I *think* the author meant something like this:

"When prices start to fall in earnest, people [i.e. consumers] lose their jobs, and get scared and start cutting back on all their purchases".

[klaudenhemet]

EXCELLENT and all very obivious. Refreshing to read Mr. Litle's comments.

[AndrewF]

Regarding "If deflation catches the world in a vice grip, gold will skyrocket relative to fiat alternatives as all paper currencies get debased." But if widespread deflation (which is the destruction of money or credit) dominates, and given that the central bankers will then be "pushing on a string", how can paper currencies then get debased?

With spiralling deflation, cash grows in purchasing power, so the real interest rate (interest rate minus inflation rate) becomes positive again, and gold tends to go up when the real interest rate is negative. Doesnt this mean gold will go down if a deflationary spiral takes hold?

This is what confuses me. My perception right now is that a deepening global depression / recession could present a fine line between circumstances that are bullish for gold and those that are bearish for gold, depending on who wins, the central bankers printing money and private banks sucking it out of the system...

[Wayne S]

In the first chart (GDX) you emphasized volume confirmation.
The second chart (recent US$ spike) omits volume information.
Why?

[TonyC-SA]

Litle: Wow, I love this article.

Jakedeez: The point of owning gold is the point of any stock; owning a share of Dell doesn't give you any trading rights to property or equipment or product, you can't go collect on your share whenever you want. You own the stock because you think the *stock* will go up. All these people arguing about whether gold can be used as currency are fools. Stocks can't be used as currency either!

In the case of Gold (IAU for instance), there is a tendency for the price to move counter to the international buying power of the dollar. It also runs counter to some stocks (but tends to move in the same direction as the S&P overall). So for some investments, you can reduce risk by making Gold a part of the mix.

The point has nothing to do with inflation or long term investment, the point has to do with the short term moves of stocks and gold and other commodities, and overall volatility. The advantage of controlling volatility is predictability, at the cost of greater upside. At an extreme for controlling volatility we just buy bonds, but even that doesn't protect you against the dollar sliding; gold does.

Personally, I keep 20-25% of my investments in gold (currently, IAU) since 2005, rebalancing every quarter. I do this because of national debt concerns, the value of the dollar is sliding and I don't think the long term outlook for that is good. If my opinion changes, so will my gold investment. Recently, gold has been tracking energy costs and those seem likely to rise long term as well.

[WolfDog]

This is a very thoughtful article. I accept the basic premise that central banks (and the politicians) will inflate to prevent deflationary tendencies of massive credit liquidation. This shakeout in gold is healthy and part of an on going bull market in AU. And 2 points: 1/ As the year winds down, hedge funds who have been long commodities have locked in some gains in order to preserve their performance fee paydays - this has nothing to do w/ the major trend of the assets, it is just a short term supply/demand factor 2/ Gold is still very cheap relative to oil. Oil is not going back to $20 or $50 soon........maybe 15 years away but the lead times on alternative energy investments are too long. So since oil will remain relatively high in nominal dollar terms, gold will also.

[The hand]

i love you gold boys. talk the price up again so i can have a ride. just don't expect me to hang on for the ride down. i do agree that if the poop hits the fan, having real assets to trade will keep food on the table. a ton of diesel and an oz of gold are almost the same price. which one would you rather have during the economic meltdown?

[marxbites]

Thomas Jefferson
"If the American people ever allow private banks to control the issue of currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers conquered."

Alan Greenspan - “Gold and Economic Freedom” 1967
"An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense – perhaps more clearly and subtly than many consistent defenders of laissez-faire – that gold and economic freedom are inseparable, that the gold standard is an instrument of laissez-faire and that each implies and requires the other. . . . This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights."

Rothschild Brothers of London communiqué to associates in New York June 25, 1863
"The few who understand the system, will either be so interested in its profits, or so dependent on its favors that there will be no opposition from that class, while on the other hand, the great body of people, mentally incapable of comprehending the tremendous advantages...will bear its burden without complaint, and perhaps without suspecting that the system is inimical to their best interests."


Curtis Dall, son-in law of Franklin Roosevelt wrote a book called FDR: My Exploited Father-in-Law in which he stated:

"For a long time I felt that FDR had developed many thoughts and ideas that were his own to benefit this country, the U.S.A. But he didn't. Most of his thoughts, his political 'ammunition' as it were, were carefully manufactured for him in advance by the CFR [Council on Foreign Relations] - One World Money Group. Brilliantly with great gusto, like a fine piece of artillery, he exploded that prepared 'ammunition' in the middle of an unsuspecting target, the American people--and thus paid off and retained his international political support."*

[TonyC-SA]

It is funny how many ideologues rail against fiat currency. Well, guess what? You are wasting your time, and anything you want you can buy with that currency. Wake up, dudes. Thomas Jefferson was wrong, I own clear title to real property, stocks, bonds, gold, diamonds, cars, electronics and more, all bought with my "fiat currency", funny money, whatever you want to call it. The fact is that stores take twenties in exchange for their goods without question. So what's the point of all this conspiracy theory that is never going to lead to anything important?

[silveraxis]

There is no such thing as volume for the forex markets as a whole, that is why there is no volume on the USD chart.

As for gold being used as money, nobody is going to spend gold in a grocery store. Even when money was based on a gold standard, gold itself rarely ever changed hands in everyday transactions. It was used to store and transport wealth and in large transactions. Most of it was used to back gold certificates. And there was silver or other metal coins and also trade bills for everyday trade (but not all of these forms had to be accepted for payment of debt, one could demand gold). So when we say "gold is money" we don't literally mean it will replace the penny, nickel, dime, quarter, one dollar bill, ten dollar bill, etc. Instead we mean that gold serves as the most liquid, immutable and internationally recognized store of wealth and means of exchange. Gold's value soars in relation to other forms of money when wealth seeks absolute safety. Even the IMF, BIS and most central banks recognize these facts, so it is a bit surprising that some of the posters have doubts here.