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• ##### Inflation And Gold: Part 2

In Inflation and Gold Part 1 we reviewed the some of the principle reasons that gold is inherently deflationary in nature.

Such examples include one of the reasons the United States rid itself of the gold standard as when economic contraction occurred, the relationship between physical dollars and the peg to gold forced interest rates higher which resulted in further economic contraction.

Thus, we didn’t have recessions but outright depressions on a regular basis (aprox every 8 years).

Furthermore the mathematical relationship between inflation and gold as it pertains to gold being denominated in US Dollars is inverse.

The higher the price in gold, the more dollars are required to purchase it. Such an increase in demand for dollars to purchase gold puts upward pressure on the dollar, not downward.

As such, the bid for gold and other commodities denominated in US Dollars is inherently deflationary in nature.

In Part 2 of Inflation and Gold we’ll begin to look at empirical evidence by way of basic statistics that show using gold as a hedge against inflation may not be such a good idea.

Inflation And Gold: Change in CPI vs Change in Gold

First we will analyze the annual change in CPI versus the annual change in the price of gold spanning from 1924 to 2010. All data has been obtained from the Federal Reserve.

The chart on the left plots the linear regression between the change in CPI (x) versus the change in gold (y).

The relationship can be explained by y = 0.546X + 0.041.

As you can see, the relationship is positive as you would think it would be as an increase in CPI represents an increase in prices. Thus as the change in CPI is positive, so is the change in Gold.

However, this view alone is not enough to fully understand the relationship between inflation and gold.

We need to look at how strong the relationship is.

We find that the R value is 0.135 with is why the relationship is slightly positive.

If you think back to Stats 101 you’ll remember that R values range from +1 to -1 with +1 representing a 100% positive correlation and -1 representing a 100% negative correlation with 0 indicating no correlation.

As you can see a value of 0.135 is much closer to 0 than it is +1 or -1 thus the correlation between the change in CPI (how inflation is measured) and the change in Gold is almost non existent.

To further illustrate how poorly the change in CPI is as a predictor of the change in gold valuation, we then look to R^2. R^2 in this sample population comes in at 0.018 indicating that only 1.8% of the price of gold is predicted by changes in CPI.

Since CPI is a basket of assets of various weights, we cannot be too surprised with the poor fit of this model.

In Part 3 of Inflation and Gold we will seek to better understand the notion of gold as a hedge against inflation is valid by further examining the relationship of Gold and CPI.

The results were alarming, even to us.

Further reading: Part 1 | Part 2 | Part 3 | Part 4

Dec 18 10:17 PM | Link | Comment!
• ##### Inflation And Gold: Part 1

Much has been said over the past few years with the respect toinflation and gold as the thought is that gold is a good hedge against inflation.

This is partially due to the thought that the price of gold stays relatively constant and the valuation of currencies merely fluctuate around it.

As a result, many people, funds, and countries, are looking towards gold as a hedge against inflation.

But is it true?

Since March 9th 2009 when the Federal Reserve announced it was expanding its quantitative easing program, the S&P 500 rallied slightly over 100% at the expense of the US Dollar. During the same period of time we saw gold also roughly double.

At first glance the view that inflation and gold are highly correlated seem valid. In fact they are perceived to be so highly correlated that people are having flash backs to the 1970s when interest rates were upwards of 20%.

Yet, interest rates among the largest nations in the world are at virtually all time lows.

What gives?

Inflation And Gold: The Gold Standard

Prior to 1971, the United States was on the gold standard. What this meant was that the value of the US Dollar was pegged to the value of gold. Valuations of currency are a direct result of the supply of currency which was adjusted based on the price of gold.

Guess what, so are interest rates.

What I am leading to here is that the relationship between inflation and gold was disastrous to GDP and Employment while on the gold standard.

How come?

Very simple.

Way back when during periods of deflation, all asset classes declined in value. The same holds true today. Thus, back when we were on the gold standard, periods of economic contraction and rising unemployment were not met with a reduction of rates and an increase in money supply in effort to spur investment.

Instead what happened was that as the price of gold fell, the value of the dollar also decreased because of the peg. However, the money supply stayed inflated on the way down.

This caused an INCREASE in interest rates to reduce money supply during periods of deflation which raised the cost of capital and the cost of investment due to the physical quantity of dollars in circulation needing to contract in order to keep the value of the dollar pegged to gold.

Such increases in rates lead the supply of money in the economy to contract when we needed it to expand the most.

This is why if you look at GNP back before the Federal Reserve was instituted we didn’t have recessions, but outright depressions every 5-8 years on average. We literally wound up having deflationary spirals on a regular basis.

Thus gold as the backing of currency was inherently deflationary and detrimental to economic growth let alone recovery from depressions.

This is partially why we saw FDR defacto try to get off the gold standard during the Great Depression.

Inflation and Gold: Modern Day

Often we hear people pointing to gold as a hedge against inflation due to the appreciation in price relative to actual inflation during the 1970s. Certainly, gold did rise in price during the 70s… it rose a lot.

However as Kindelberger put it “Gold was going up because gold was going up”. What he was describing was a mania… before the panic and subsequent crash.

This day and age, people seem to forget one important aspect of the deflationary quality of gold that, while no longer on the gold standard, we cannot get away from. At least not those of us in the United States.

That is, the relationship between inflation and gold is mathematically inverse.

How?

Simple…

Gold is priced in US Dollars.

This means that as the demand for gold increases, the demand for dollars also increases. Not only domestically but also abroad. So if you refer back to economics 101 you’ll remember that as the Qd USD rises so does P.

And what does a rising dollar spell?

Deflation.

So how is it that if the bid for gold is inherently deflationary due to an increase in demand for dollars that we had such a huge run up in gold and inflation during the 70s?

First we have to compare like versus like as Milton Friedman always said.

The size of the market for gold back in the 70s was much smaller than the size of the market for gold is today. So the relative bid for dollars was much smaller than it is now.

Electronic trading and further advancements in technology have greatly reduced the cost to participate in such markets in addition to their accessibility increased via ETS and other such investment vehicles.

Currently as of tonight (12/12/2011) the total value of the GLD ETF (which is traded heavily on our Virtual Prop Desk) is \$71,168,045,704.04. That’s a 71billion dollar bid for dollars to buy gold that didn’t exist back in the 70s. Furthermore this doesn’t include the bid for dollars in the futures markets, physical etc. It winds up being a lot of dollars that as being bid for in order to purchase gold.

This also doesn’t include the foreign bid for dollars to purchase gold either.

Second, all things are relative meaning that while the market for gold was smaller in the 1970s than it is now, the demand for dollars was still elevated relative to demand for dollars when gold was cheaper. As such, we have to look at what inflation was versus what it could have been  if the bid for dollars wasn’t as large.

Had gold not risen in the 70s, inflation would have actually been higher.

This is why the price of gold has put a thorn in the side of the Federal Reserve during the recent QE programs. The more they ease, the more of that money has gone back into the US dollar to buy gold effectively nullifying (at minimum retarding) the impact of QE programs on the economy. Simply put their efforts to create inflation hasn’t actually worked.

Inflation and Gold Part 2 will begin to take a look at various different statistical measurements to quantify and visual see the relationship between inflation and gold.

You will be shocked by what you see and by what is on the horizon for the price of gold!

Further reading: Part 1 | Part 2 | Part 3 | Part 4

Article originally from http://bidhitter.com
Tags: GLD, GDX, gold, inflation
Dec 17 8:08 AM | Link | Comment!
• ##### What a Late Day Rally Really Means
I happened to have the TV on, which is rare, and happened to have on Cramer, which is even more rare. He started off his segment by talking about the very same topic I had planned for today. Naturally my ears perked up. I didn't catch the entire bit verbatim but I think i got the jist. "Late day market rallies indicated that we're in a real bull market that's being held up because of positive news."

Apparently if we pump the air waves full of positive news, markets will rally.
The inverse would mean that if we pumped them full of negative news, they will decline.

But is this true?

No.

Here's why...

We know this to be not true for a million reasons, but the one most easily grasped is that back in March of 2009 and beyond we were inundated with negative news, yet asset prices rose. I'm also sure you've seen situations where your favorite stock reported good earnings yet the price sank like a ship.

"Oh but it's already priced in..."

Right....

Prices move based on supply and demand.

Prices only move on supply and demand!

What a late day rally REALLY means:
The next time you see a late day rally, pay close attention to the volume. When we see AM sell offs, they are occurring on consistent or increasing volume.

Until something happens...

Volume suddenly drops.

The volume drop that you are seeing after declining prices is quite literally the supply running out, dropping off, declining, sellers leaving, whatever you want to call it. The net result is the SAME. Supply has run dry!

When surpluses becomes shortages, we have increasing demand and increasing prices that naturally follow.

This is precisely how we get late day rallies. This is also precisely why we have "no volume" rallies that people think is a sign of weakness.

Price APPRECIATION on low volume is NOT weakness.

The FAILURE of price to appreciate on low volume IS

View exactly what this looks like on the BIDHITTER blog
Tags: SPY, QQQ, DIA
Jan 10 7:53 PM | Link | Comment!