Justice Litle's  Instablog

Gold stocks could be headed for an epic bull run, of the sort not seen since the heady inflationary days of the late 1970s. Justice explores the logic behind a sustainable bull move.

Yesterday we highlighted the drivers behind the major breakout in precious metals stocks.

Today we’ll touch on a few factors as to why this move could be sustainable... the opening stages of a major bull run.

Gold Stocks Bull Run Reason #1: Volume Tells the Tale

As mentioned on Tuesday, the big breakout in gold stocks came on a major volume surge. If you compare the volume bars for last week’s big GDX up days to the more typical volume of the past few months, the visual is that of a 7-foot NBA center (Shaquille O’ Neal or Yao Ming maybe) signing autographs for a crowd full of midgets.

Volume is a useful tool in separating real from fake when it comes to range-expanding moves. Volume is also a useful market tool in that it speaks to the beginning and ending of things.

A surge in volume, when accompanied by a surge in price, is like an exciting chapter in a mystery novel. The story can be just unfolding, or it can be resolving to a powerful conclusion, depending on the context.

The logic here is simple to understand. When investors and traders pile into (or out of) a market in huge size, that indicates either a major shift in sentiment or a major climax in existing sentiment.

For example, when a market has been going up and up, and then there is a huge surge in both volume and price, that suggests a blow-off top. (The same is true in reverse for bear markets on the downside.)

Conversely, when a market sees a major surge in price and volume that runs counter to the current trend... or comes after a period of consolidation and quiet... that suggests that sentiment is resolving in a powerful new direction.

This is what the price and volume action in gold stocks seems to suggest. After a peak in late May, GDX went mostly nowhere – down and sideways – for months, as investors grew preoccupied with speculative fly-by-night plays like junky financials, dicey consumer retail and the rest.

Of course, volume is not a fool-proof indicator. (In fact no such indicator exists – unless one is willing to require so much confirmation that half the move has already happened before one gets on board!) That is why it’s important to judge the story itself... to make sure that the narrative makes sense.

And in this case the narrative makes a lot of sense. Cash-flush money managers and uneasy investors are rotating their money into gold stocks because, in the back of their minds, they know the V-shaped recovery story has holes in it big enough to drive a Mack Truck through. They know it makes sense to find a place to hide. Last week’s surge in volume tells us that this anticipated shift in sentiment is now well underway.

Gold Stocks Bull Run Reason #2: “Double Dip” Recession Odds Are High

Rather than hit you over the head with a phone book full of depressing facts, your humble editor will ask you to take his word for it on this one. At this point in the cycle, odds of a “double dip” recession are very, very high.

There are numerous reasons as to why this is so... reasons we have painstakingly enumerated in Taipan Daily (and which we will surely be revisiting).

The trouble is, in his post-depressive manic hope-jag, Mr. Market has failed to consider the odds of a double dip recession. In fact he has pretty much failed to consider anything, except the hole cards right in front of him.

To expand on a poker analogy, novice players often make the mistake of only playing their hole cards (the cards in front of them). Such players are oblivious to the nature of their opponents, the texture of the flop, or anything else that would normally be a factor in decision making as to when to check, raise or fold.

When such a player decides that, say, pocket tens are a “strong” hand, he will not fold and not back down, regardless of what ominous signs are staring him in the face.

But this bubble of obliviousness can only last for so long before it gets popped. Now that bubble is in the process of being popped as harsher realities come to light. Factors that were successfully ignored for months, swept aside by an extremely favorable run of cards, loom large.

It may not be polite to say in mixed company, but the very factors that make for a coyote-ugly economy also serve as a very strong backdrop for gold stocks... it’s no coincidence that gold stocks did well, for example, in the depths of the Great Depression.

The Biggest Bugbear: Deflation Pressures

If one had to lay out the most serious risks to a “bullish gold stocks” thesis, they might run as follows:

            • The broader economy thoroughly revives, making gold stocks passé as an investment choice.

            • Cost factors like fuel, equipment and skilled labor grow so high as to erode gold miners’ earnings.

            • Deflationary pressures grow so strong that the entire market is dragged down – gold stocks too.

The first factor does not present much of a worry. Via massaged government data points that look shiny on the surface but rotten underneath, we are already getting a clearer picture of the U.S. economy, and it is not a pretty one. Bullish noises from traditional stats like unemployment and ISM merely serve to make a mockery of the real carnage taking place, with the pain landing squarely on the shoulders of small businesses and unemployed (or involuntarily “self-employed”) workers who do not show up on the jobless rolls.

The second factor does not present much of a worry either. Ironically, the deflationary headwinds (in the form of falling wages and profits) bearing down on the market are good for the gold miners in terms of reducing fuel, equipment and labor costs.

It may indeed be that oil makes its way back to $200 per barrel at some point... but gold would likely be $2,000 an ounce (or more) in such an instance, as $200 oil is practically synonymous with U.S. dollar collapse.

The real reason to doubt a bullish gold stock outlook, then, comes down to deflationary pressures. While commodity prices are walking an intriguing tight rope thanks to factors like Chinese stockpiling and U.S. dollar erosion, other major factors are pointing very much in a deflationary (falling price) direction:

            • falling wages

            • falling revenues

            • brutal cost cuts

            • imploding state budgets

            • contracting credit lines

            • rising unemployment

            • rising credit defaults

            • rising construction loan defaults

            • rising government debt issuance

            • rising consumer savings (long-term trend)

Hard assets aside, such factors are powerful bad juju when it comes to deflationary risks. If a “double dip” recession indeed takes hold – a possibility more likely than not in your humble editor’s estimation – the result could be a classic equity implosion, of the sort to send equities back to the general vicinity of the March 2009 lows (if not guaranteeing an actual test).

The grizzliest of deflationary bears argue loudly that the U.S. Federal Reserve (and various central bank counterparts around the globe) are helpless in the face of such headwinds, doomed to the prospect of “pushing on a string” – that is to say, flooding the economy with liquidity to no avail.

The classic liquidity trap is one in which all the excess liquidity created simply pools unused in bank vaults... like water in underground reservoirs that never gets distributed to an economy in drought.

And yet, and yet. Central bankers may be dumb and blind, but they are not deaf! They have heard this deflationary drumbeat ringing in their ears all too clearly. Which leads us to...

Gold Stocks Bull Run Reason #3: Central Banks Are Getting Creative

The Bank of Sweden, known informally as the “Riksbank,” is the oldest central bank in the world. Official Riksbank operations began in 1668, some 245 years before a cabal of top-hatted schemers convened on Jekyll Island to dream up the Federal Reserve.

Now the Riksbank has made financial history again by being the first to go “negative.” As the Financial Times recently reported (underscore emphasis mine),

            For a world first, the announcement came with remarkably little fanfare.

But last month, the Swedish Riksbank entered uncharted territory when it became the world’s first central bank to introduce negative interest rates on bank deposits.

Even at the deepest point of Japan’s financial crisis, the country’s central bank shied away from such a measure, which is designed to encourage commercial banks to boost lending.

But, as they contemplate their exit strategies after the extraordinary measures of the past two years, central bankers will be monitoring the Swedish experiment closely.

What does this mean? In practice it means that modern day central bankers can look deflation in the eye and say “liquidity trap be damned... we will do WHATEVER IT TAKES to win this war... including measures far above and beyond what timid Japan was willing to do.”

Japan was perpetually timid, in part, because the majority of Japanese government debt is held “in country,” that is to say, by Japan’s own corporations and citizens. America, in contrast, has no such natural restraints. If the Riksbank can impose negative interest rates on bank deposits, then you damn well better believe the U.S. Federal Reserve can too.

The Fed, in other words, can all but come around to your house and set fire to the mattress if it chooses. Those who stuff cash under the bed in anticipation of an unavoidable liquidity trap could see that cash burned up by measures never before seen... which the centuries old Riksbank has already shown the way on implementing.

And that leads us to perhaps the biggest reason of all why gold stocks could run...

Gold Stocks Bull Run Reason #3: The Biggest “Side Pocket” the World Has Ever Seen

To quickly recap, we know there has been a major sentiment shift in favor of precious metals (as indicated by surging volume after a period of consolidation). We know the broad economy story is ugly and getting uglier, and that gold stocks historically did well in the Great Depression. We also know that traditional “liquidity trap” fears, of the sort that sucked Japan under, may also be invalidated by the willingness of central banks to try fantastically aggressive never-before-used measures (like negative interest rates on bank deposits).

Finally, we know that democratically elected governments are dumb as a general rule of thumb... and that mass stimulus efforts essentially never work.

By their very nature, democratically elected governments are shortsighted to an almost crippling degree. This can be chalked up to short-term political time horizons. With politicians overwhelmingly focused on how to get re-elected in a short period of time – the window between campaigns measured in months rather than years – long-term solutions requiring short-term pain never get implemented. Instead, lip service, pandering and reckless splurging are the constant choice.

So ask yourself, then, what happens when the following three elements are combined:

            • An economic situation that is virtually guaranteed to get far worse before it gets better.

• A central bank (actually a whole host of central banks) hell bent on beating deflation “no matter what,” with a willingness to implement measures Japan never contemplated... which in turn means not just keeping interest rates low for years, but setting proverbial fire to bank vault cash if need be by way of negative interest rates.

• A rapidly eroding faith not just in the U.S. dollar, but in the solvency and viability of virtually all Western World fiat currencies, as the corrupt incompetence of Keynesian thinking comes to light.

The net result of this unholy trinity is a massive pool of artificially generated liquidity with absolutely nowhere to go.

Government efforts to kick start the economy will prove to be the equivalent of flooding a lawn mower engine with gasoline. Beyond a certain point, the extra effort doesn’t do a damn bit of good. Meanwhile, all that extra liquidity created and force-fed into a low-appetite economy will have to go somewhere... and as general faith in the system hits new low after new low, it could pour directly into the “side pocket” of gold and silver stocks. After all, money flows to where it is treated best... and if the Feds beat the crap out of money held in bank vaults in a deflation-dominant environment, it will flow to the next best proxy of safety and soundness – precious metals and the miners who produce them.

This is a potential multi-year trend we are talking about here. Think back to the great oil run of the late 1970s, and the incredibly entrenched nature of inflation psychology that gripped the nation by the time of the 1980 peak.

When gold stock mania is as thorough and entrenched as housing mania was circa 2006, with all the media circus and breathless hype that entails, that’s how you’ll know the run has played itself out.


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The announcement of Ben S. Bernanke’s successful nomination for a second term brings forth a curious question. Whom does the Fed Chairman really and truly work for?

Before we get into today's topic, a quick comment on the state of the market here and now.

There is a bit of debate going round as to whether traders should be anticipating the demise of the epic 2009 market rally... washing their hands of the nutty action entirely... or jumping back in, jack-be-nimble style, to catch a piece of the last hurrah.

Different traders will come to different conclusions, of course. It takes all kinds to make a market. Just two quick observations and we'll move along.

First, there is a reason they call it "greater fool theory." And second, trends have life spans – just like people.

Trend mileage can vary widely, of course. But this is true of people too. Statistically speaking, a Japanese woman has far better odds of reaching 85 than a Russian man does of reaching 65.

Point being, when your humble editor looks at this market rally from a trading perspective, he does not see a bright-eyed Japanese grandmother puttering around in her garden. Instead he sees a 64-year-old Vladivostok dock worker... an ashen-faced, barrel-chested man with a heaving cough, a clogged aorta, and a mean addiction to Stolichnaya vodka and Sobranie cigarettes.

But, as Dennis Miller used to say, "That's just my opinion. I could be wrong..."

Two Cheers for Fireman Ben

In a notable bit of inside baseball this week, the Chairman of the Federal Reserve (Ben S. Bernanke) was officially locked in for a second four-year term.

Breaking the news from an elementary school gym in Martha’s Vineyard – Mr. Bernanke by his side – the vacationing Prez was effusive. "Ben approached a financial system on the verge of collapse with calm and wisdom; with bold action and outside-the-box thinking that has helped put the brakes on our economic freefall," President Obama gushed.

Of course, there was no real mention of the serious Fed-induced problems that brought the financial system to the “verge of collapse” in the first place. Lest we forget, Bernanke stood shoulder to shoulder with his predecessor, Alan Greenspan, in regards to ignoring bubbles until they burst (“Bubble, what bubble?”)... injecting massive liquidity into the system post-crisis and leaving it there, reinflating new bubbles from the dregs of popped old ones... and, last but not least, in coming up with fanciful theories to blame fiscal imbalances on other nations (the infamous “global savings glut”).

For the POTUS to touch on such things would have been a breach of protocol. Instead, the regulator who almost burned the house down was lauded for knowing how to use a fire hose.

Bernanke “saved the world,” the Fed Chairman’s most enthusiastic boosters declare. Never mind that he saved it from the leverage-loving pyromaniacs (i.e. short-sighted greedy bankers) that were supposed to be under his watch in the first place.

Who Is This Man’s Boss?

In light of the Bernanke reappointment, now seems a good time to ask a curious question. Who does the Fed Chairman actually work for?

The obvious answers don’t quite jibe. The POTUS and Congress, for example, supposedly work for you and me. In theory, at least, they are held to account by the voting process and beholden to “the American people.”

But the Chairman of the Fed is not exactly elected. He is more or less anointed by way of smoky backroom horse trading, in which there is a lot of whispering and assurance-seeking before the Chief Executive reluctantly agrees to endorse.

Does the Chairman work for the President or Congress then? Not exactly... the Federal Reserve is a proud and unbending institution, fiercely protective of its cherished independence. There is definitely a kabuki dance of forged alliances, cultivated relationships, and so on. But a good Fed Chairman works the aisles up and down the Hill precisely so the Fed can maintain its vaunted independence, not give it up. Keeping Congress’ greasy mitts off the true levers of power is a top priority.

So perhaps the Fed Chairman is like a Supreme Court judge – appointed by the President and vetted by Congress, but hypothetically free of political influence thereafter. That, in turn, would make the Fed a quasi-official “fourth branch” of government, giving us the Executive... the Legislative... the Judicial... and the Financial.

The Supreme Court analogy hits uncomfortably close to home. The Fed no doubt despises any such “fourth branch” references, not because they are unflattering or inaccurate, but because such talk reveals too much. (Better not to give Congress any wild ideas, re, reining in the Fed’s power.)

Follow the Money

Yet there is something lacking in the Supreme Court analogy too. The black-robed nine spend their days solving thorny legal issues, handling landmark court cases gathered from across the land. To be a Supreme Court judge is clearly to be in thrall to American law, and to be in devoted service to an abstract ideal. The Fed has a far murkier agenda...

If we look not to words but deeds, the picture becomes more clear.

For instance Dennis Lockhart, the head of the Atlanta Fed, admitted in a Chamber of Commerce speech this week that the real unemployment rate is actually 16% (as opposed to the official July jobless rate of 9.4%). Such a number surely implies the Fed is not all that concerned about the working joes of this country.

Yet another Fed head, James Bullard of the St. Louis branch, further admitted last week that the Fed plans to keep interest rates “exceptionally low for an extended period of time,” according to Reuters. “I don’t think markets have really digested what that means,” Bullard added. If anything it means the Fed is more concerned with pumping up paper assets than protecting consumers and businesses from nominal price hikes.

Perhaps the question can be answered with a question. Who was the Federal Reserve meant to regulate? It is a paradox of government that the law-wielding regulators often find themselves kidnapped by the regulated... brain washed in a weird case of bureaucratic Stockholm Syndrome.

From a power and money perspective, regulatory Stockholm Syndrome makes perfect sense, however, because so much of both – power and money, that is – is concentrated in the private sector. The top four banking behemoths all have deposit bases measured in the trillions, for example. Is it any wonder the Fed, Treasury and FDIC merely kowtow?

Meanwhile, top Wall Street bank execs enjoy bonus-laden paydays in the tens to hundreds of millions. In stark contrast, the Federal Reserve Chairman’s 2008 salary of $191,300 is less than half the guaranteed minimum a rookie MLB relief pitcher would get... the Goldman Sachs equivalent of a waiter’s tip.

Ladies and Gentlemen, We Have a Winner...

When one considers the possibility that the Fed Chairman actually works for the banks, all the pieces begin falling into place.

It’s only natural, after all, given that the original mandate of the Fed was to preserve banking stability. It is the Federal Reserve’s job, first and foremost, to make sure that the U.S. financial system (and by extension the executives who stride atop it) perseveres through all economic storms.

In principle, the good of the country and the good of the U.S. financial system are supposed to be one and the same thing. In practice, the two can be at odds, sometimes dramatically so.

The charade of pretending that the two considerations are one and the same, though, is a key aspect of the brilliant bait-and-switch job foisted upon us all. Whenever a Fed (or Treasury) official’s actions can be wrapped in the guise of “saving the system,” it is implied that said action was undertaken for the good of everyone. Ha!

What’s more, not all bankers are created equal... as with seating arrangements in the king’s court, it is always better to be closer to the throne. Given their combination of heft, gravitas and “too big to fail” status, the top four banking institutions probably wield more power and influence than the next 40 combined. And beyond that, no man’s land. One can trace out the priorities of the Fed and Treasury in real time by observing how the giant money center banks get attended to hand and foot. The Bumbershoot Bank of Kalamazoo Kansas, meanwhile, is left to choke on prairie dust.

Banana Republics and Dictatorships

The main trouble with arrangements like this one is the way they tend to be favored by banana republics and dictatorships. When a small, concentrated “elite” class is consistently favored at the expense of everyone else, the long-run result is rarely pretty.

A tendency to endorse “socialism for the rich, capitalism for the rest,” as James Grant and others have put it, is not the best recipe for sustaining and growing a free-market economy. Unfortunately, in granting semi-autonomous power to a “fourth branch” mainly beholden to the banks, that is pretty much what the United States has signed up for.

Simon Johnson summed up the forward-looking concerns nicely in a recent Seeking Alpha piece, “Is a Two-Track Economy Emerging from the Rubble?”

The United States has, over the past two decades, started to take on characteristics more traditionally associated with Latin America: extreme income inequality, rising poverty levels, and worsening health conditions for many. The elite live well and seem not to mind repeated cycles of economic-financial crisis. In fact, if you want to be cynical, you might start to think that the most powerful of the well-to-do actually don’t lose much from a banking sector run amok – providing the government can afford to provide repeated bailouts (paid for presumably through various impositions on people outside the uppermost elite strata).

If we as Americans still have some true fighting spirit left in us – and enough of a grasp on revolutionary history to spark it – then perhaps Fed Chairman Bernanke will get more than he bargained for in the next few years.

What do you think? Does the Fed Chairman work for the people... or the banks... or someone else entirely? Is he doing a good job, or should we listen more to the Ron Pauls of the world and take some kind of action before it’s too late? You can deliver the full force of your opinions here: justice@taipandaily.com

Warm Regards,

JL