Demystifing What Gold is Telling Us

Well, gold bugs around the world have been having a good chuckle of late, as the market is re-affirming the often eccentric and religious-esque views of gold bugs: gold is up over 11% for the year in US dollars, and up over 4% over just the past five trading days. Which begs the question: why? There are a few possible answers to this question:

1. Deflation. This crisis is global, and everyone is flying to safe stores of wealth. Over the big picture of human history, gold has served as the best store of wealth -- and thus gold is rising. In many ways this is the classic "gold is money" argument, one typically championed by Austrian economists. Robert Blumen has offered an excellent explanation of this argument.
2. Inflation. Gold is typically a hedge against inflation concerns, and as the US federal government continues to aggressively "stimulate" the economy, the rally in gold may be a reflection of increased concerns regarding inflation.

So which one is it?

In my opinion, both. With that said, I view inflation as the larger concern, as I have said many times before. If the environment were truly deflationary, Treasury bonds would be the true recipients of flight to quality, as well as dollar holdings in FDIC insured banks. Instead, 20+ year Treasury bonds have fallen by more than 13% thus far (as measured by TLT). Negative correlation between TLT and precious metals suggests inflation, not deflation. The chart below illustrates.

Deflationists will point to the fact that the US dollar may be strengthening relative to other fiat currencies -- although this is not necessarily a reflection of deflation, as it could simply be interpreted as weakness of all global currencies, all of which are falling against gold. More relevant may be the rise in PPI and energy prices in January of 2009. While one month alone does not provide sufficient evidence for a substantive reversal in macroeconomic trends, it is not consistent with deflation, and may suggest that the Fed's inflationary actions in the second half of 2008 may be kicking in.

Conclusions for Trading

The recent activity in the market has led me to make the following revisions:

1. The forex market is increasingly a trader's environment, perhaps even a daytrader's environment.
2. Gold and silver may retrace, perhaps even by several hundred dollars, though I would view it as an opportunity to buy on dips. The global economy is getting worse and conditions are being aggravated by the actions of central bankers. As a result, the fundamental case for gold and silver will get stronger.
3. Counterparty risk is rising -- this strengthens the argument for increasing the physical delivery portion of one's precious metals portfolio.
4. Because of inflation concerns, my bias is against short positions in all asset classes. If I were a trader of stocks or commodities, I might look into shorting positions relative to a broader index (i.e. short a particular stock while going long the sector ETF, under the rationale that the stock will do worse than the entire sector).
5. Oil's behavior has been quite peculiar; I've yet to find a convincing explanation for why it's moving the way it is. As it escapes my fundamental analysis, and as I find it less appealing than currencies from a technical analysis perspective, I'll stay away from oil.
6. As gold becomes too expensive for many, silver will grow in appeal. And as silver fell more than gold during the second half of 2008, it may be set for a larger rally.

Disclosure: Long gold and silver.

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Copper And Base Metals May Be Good Way to Profit from Inflation

Copper has become a renewed subject of interest, as some market prognosticators view copper as a leading indicator of the economy as a whole. This results from the fact that copper is used in a wide variety of businesses -- industrial products, semiconductors, infrastructure, etc. -- and thus changes in copper prices can signal big changes in sectors that are copper-dependent. Currently, copper prices are rising, which could be interpreted as businesses showing an interest in buying copper because of an increased willingness to assume risk and invest in certain sectors of the economy.

The chart below illustrates. The transportation and semiconductor sectors tend to be particularly dependent upon copper, and thus included ETFs that track them (XSD for semiconductors and IYT for transportation) in the chart below; we may be able to learn more about which sectors in particular are moving.

While semiconductors have been rallying since mid-November, the transportation sector continues to be devalued. Moreover, the overall demand for copper is declining around the world, as this Bloomberg article notes, and has decreased copper mining efforts.

As platinum, silver, and gold continue to rise while Treasuries continue to fall, copper's rally may signify greater inflation concerns. As metals have rallied while commodities have remained stagnant, the market may be signalling greater concerns about inflation in the midst of a lack of investment opportunities.

Thoughts on Trading

Copper has taken a particularly harsh beating thus far, as the chart above illustrates. As such, the bottom identified in the chart may be a critical level to watch to gauge broader macroeconomic trends; a break of that level could signify the next leg down for equities.

Conversely, copper may be a better play for those looking to profit from reflation of the money supply. As copper has fallen more than many other metals since falling asset prices set in in August of 2008, it may be due for a larger correction.

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A Bull Market in Stocks Could Result from Significant Inflation

Puru Saxena of Money Matters recently wrote an article entitled "Birth of a New Cyclical Bull?" in which he offers arguments for why we may see 2009 be a bullish year for equities. His basic points:

• Inflationary actions by the Fed and declining TED Spread have proven effective in fighting falling asset prices and reducing risk
• Treasury bonds need to have higher yields or money will go into equities
• Equities have "overshot" to the downside, thus resulting in excessively low valuations

I agree with Saxena's basic premise that the Fed's actions will be successful in creating in inflation in the aggregate; it is only a matter of which asset class will reap the benefits of the inflation, and who will pay for it.

The chart below compares various asset classes against one another for the month of January.

A key question we may wish to begin asking and examining is just how much inflation the Fed has really created for us, something that will become more apparent as lending resumes and money that is "on the sidelines" returns to the game. I'm of the viewpoint that the global economy is currently improperly structured, and needs a complete restructuring, one that will likely require abandonment of the US dollar as world reserve currency, a corresponding decline in US consumption, and a significant restructuring of the FIRE (finance, insurance, real estate) economy in the United States. From that perspective, an equities rally will be unsustainable, unless there is currency debasement to the extent that all markets rise nominally. If that is the case, though, the inflation will result in significant dollar devaluation.

Trading Implications

The fall in Treasuries was the story for January, and will be of importance so long as it continues. If money comes out of Treasuries and into equities and commodities, it increases the likelihood of seeing consumer price inflation. As I've stated before, though, I expect commodities to outperform equities once money comes out of Treasuries and dollar devaluation resumes. And as all currencies around the world are having trouble, gold will continue to rise as fiat currencies continue to struggle.

Disclosure: Long gold.

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Money Coming Out of Treasuries And Into Gold

To understand how the macroeconomic picture is changing, we can take a look at how various asset classes are changing relative to one another. With that in mind, see the chart below, which shows the ETFs for four asset classes -- Treasuries, gold, commodities, and the S&P 500 -- to see where money is moving.

The chart illustrates the following:

• 20+ year Treasury bonds were rising, but now appear to be consolidating and possibly turning bearish
• S&P is rangebound between 850 and 950
• Gold is rallying
• Commodities are still in a bear trend

Interpretation

The rise in gold coupled with weakening Treasury bonds, commodities, and S&P suggests the market is still rooting out false forms of wealth -- and that the market is shifting to gold as its preferred method of safety. Inflationists will posit that the rise in gold results from greater inflation concerns, and this may play a part into it as well; money supply indicators and money velocity indicators are both pointing to inflation.

Trade Setups

Two potential trade opportunities come to mind:

1. Betting on a continued exodus from Treasuries into gold, in that the market will continue to favor gold over Treasuries as a safe haven
2. Long commodities relative to S&P; commodities seem grossly underpriced relative to the S&P, doubly so for those expecting a deflation spiral.

Disclosure: Long gold.

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An Inside Look at the Beef Between Mike Shedlock and Peter Schiff

The Austrian economics blogosphere was rocked to its very core yesterday, when Mike Shedlock, one of the most popular economics bloggers on the web, dropped a serious smackdown on Peter Schiff in a post entitled, "Peter Schiff Was Wrong." In this post we'll analyze the beef between two of the most prolific economists of our time.

Meet the Contestants: Peter Schiff vs. Mike Shedlock

Peter Schiff: Adheres to the Austrian school of economics. President of his own brokerage firm, Euro Pacific Capital. Here's his web site.

Mike Shedlock: Austrian economist. Investment advisor. Prolific blogger -- check it.

Like any great rivalry -- Ali vs. Frazier, Google vs. Microsoft, Batman vs. Joker, etc. -- Schiff vs. Shedlock is not without history; see their previous debate.

Now that we've met the contestants and know the history of this longstanding rivalry, let's take a look at what it's really about.

Schiff vs. Shedlock = Dead Dollar vs. Rangebound Dollar

It's crucial to note that Schiff and Shedlock agree on quite a bit. Such as:

• Gold will rally
• US stocks will decline
• Japanese yen will appreciate

Their primary point of contention is their debate on what will happen to the US dollar. Schiff thinks the dollar is doomed and will lose more than half its value over time; how long is unclear, though Schiff has been anti-dollar for some time (since at least 2002), and is sticking to that as the long-term trend. Shedlock, on the other hand, thinks the dollar will be rangebound and is not expecting to see the dramatic decline Schiff is expecting.

Schiff is referred as an inflationist, while Shedlock is a deflationist. It is crucial to note the terms inflation and deflation refer to money supply, not prices. Thus, a key difference in the analysis of Schiff and Shedlock is that most inflationists will use MZM as a money supply indicator, while Shedlock and other deflationists are more inclined to use something else. As a result, the issue of how best to calculate money supply also plays into the heated rivalry between Schiff and Shedlock.

Secondary Conflicts Over Treasuries and Commodities

Their conflicting views on the US dollar lead to conflicting views on other asset classes -- namely government bonds (i.e. Treasury bonds) and commodities. Commodities are traditionally anti-dollar investments; if you think the US dollar will fall, buying commodities is a way to hedge against this. This was proven to commodities investors who enjoyed the rally from 2002 to mid-2008, which coincided with ongoing dollar devaluation. Likewise, bonds are typically favored when investors "go cold" and look for safety -- but are dreaded by those who view currency devaluation as a great concern.

Sizing Up Schiff

Peter Schiff is an icon of sorts amongst bears, as he has been the most successful in breaking the "bear barrier" and expressing bear ideology to millions via regular appearances on national television. Personally, I agree with Schiff's long-term fundamental analysis, which is bullish for commodities, metals, and Asia, while bearish on the US economy. I think dollar devaluation is baked in, that there is a bubble in Treasuries, and that once this bubble pops, a run on the dollar will ensue (the Argentina and Iceland scenario).

With that said, as Schiff himself admits, it is unclear when the bubble will pop. Bubbles can go on for a few years, and during that time, clinging to your investment thesis can hurt -- and Schiff's overall thesis did not fare well in 2008, as his archnemesis Shedlock is fond of reminding us. For that reason, I think it would be advantageous to couple Schiff's fundamental analysis with momentum following technical analysis. This is essentially my trading strategy, and 2008 was a healthy and profitable year for me -- as it was for anyone who coupled Schiff's views with technical analysis.

Sizing Up Shedlock

There is no denying Shedlock is an excellent economist, and he deserves much credit for being one of the few people who called for a strong rally in the dollar, US Treasury bonds, and a decline in commodities. While most perma-bears and Austrian economists saw the collapse of XLF (financials) and XHB (homebuilders) coming, a more common view was that the bubble would go to commodities, where it would stay and grow. Thus the calls of oil going to $200 (which is something I must confess to having said, but not traded). And we did proceed on this path -- oil got above $140 -- but then came sharply back down, and the bubble was passed to Treasuries.

Ultimately, Shedlock thinks the Treasury market is safe, and is not one of those concerned about a potential collapse in Treasury prices. Shedlock maintains this concern when wealth contraction occurs around the world, thus leaving less investment dollars available for foreigners to buy US Treasury bonds, and also while gold and silver become increasingly popular alternatively stores of wealth, something which Shedlock correctly forecasted. And he maintains the stability of the Treasury bond market when supply is set to increase significantly given Obama's aggressive stimulus mandates and philosophy of "deficit's don't matter."

The Key Factor: To What Extent Is Monetary Policy Fiat?

So who's the winner? Schiff or Shedlock?

Well, as noted previously, I consider both to be outstanding economists, and thus they have already won in the eyes of this judge. In terms of whose investment thesis will prove to be more victorious, however, much of it will boil down to one key question: is monetary policy fiat? Meaning can the Federal Reserve inflate if it wants, and deflate if it wants?

Deflationists will argue that because the Federal Reserve cannot force banks to lend, it cannot affect the portion of the money supply that is created by commercial banks when they lend money into existence, and that credit destruction (declining availability of credit and falling asset prices) will result in a declining money supply. Inflationists will argue deficit spending, interest rate cuts, induction of sell offs by foreign central banks, and coordinated activity with other central banks can always result in inflation, provided there is no restriction on money supply, like a commodity standard that guarantees the value of each note of circulation with respect to a commodity.

In my opinion, the Federal Reserve can inflate if it wants, and that monetary policy in an economy with a central bank a fiat currency is a fiat matter -- if inflation is decided, than that is what shall happen. As Bernanke and friends still view inflation as the solution and view deflation as intolerable, I'm inclined to think inflation/currency devaluation is the greater concern, and that Schiff's long-term thesis is still correct.

Alternatives to Schiff and Shedlock

There are those who may find Schiff and Shedlock to both be unsatisfying in ways, and thus may find the rivalry to be less than compelling. For those folks, I'd recommend Eric Janszen and Stefan Karlsson.

For another take on Schiff vs. Shedlock, see this commentary from David Waring.

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If Inflation is Institutionalized, We Need to Learn Short-Term Trading

Inflation is and has been the monetary policy of choice since the gold standard was fully abolished in 1971. See the long-term money supply chart below.

Consequences of Institutionalized Inflation

The key question for investors and traders: what are the consequences of inflation being institutionalized as monetary policy?

1. It leads to a "pass the bubble" economy. When the Federal Reserve inflates to counter deflation, the excess money supply will be directed into an asset class besides the ones being deflated, thus leading to a new bubble. The bubble in US Treasury bonds is the current example of this.

2. It leads to more of a fiscal-based economy, not a production-based economy. The creation of money and the financial markets, rather than market demands, guide investment and production.

3. As the fiscal economy -- the financial institutions that profit from the creation of bubbles -- becomes the dominant part of an economy, the largest incentives are in speculation and enabling speculation.

4. It's a trader's not an investor's, paradise. A "pass the bubble" economy is, in many ways, a short-term trader's dream come true. When an economy becomes more driven by monetary policy than by market demand, speculation becomes more profitable than production.

5. Consistent with the notion that institutionalized inflation favors traders, analytical tools like technical analysis and short-term money management practices become an increasingly important tool in forecasting price movement.

6. Because legislation and brokerage firms can steer the Federal Reserve's inflation into certain asset classes, sector trading -- trading based on the correlation between sectors -- may become more lucrative. The proliferation of ETFs facilitates this.

Other Key Considerations

It's worth noting that bubbles can last for quite a while. In fact, there are those who argue there is a bubble in Treasury bonds, and that it will last a while -- thus creating a prolonged deflation in the economy. As always we can look for momentum in price charts and potential outlier, "black swan" events to understand when the bubble is being deflated and how monetary policy will try to reflate.

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The Aggregator Bank Intervention Trade

In its simplest form, the financial mess could simply be explained as a bunch of bad loans being made -- loans to home buyers who couldn't really repay the loans, banks taking on too much debt due to the securitization of loans, and government issuing more debt than its tax base can handle.

The government response has been to try to bailout the bad debts through the usage of taxpayer funds and obligations. To this end, the Obama administration is now considering the creation of an "aggregator bank" -- one that will buy up bad loans, under the rationale that this will relieve the banks and cause them to lend.

As market speculators, there are a few things we should consider:

1. Whoever holds the bad loans is holding an asset that needs to fall in value. If the US government creates an aggregator bank specifically to acquire bad loans, the US government will bear the loss. As the US government borrows money, it would mean Treasury holders would bear the loss. Should appetite for Treasuries dry up, the dollar will be devalued, and US dollar holders will bear the loss.

2. As such, bailouts are a way of transferring market losses from financial institutions to taxpayers. An opportunity to trade this would be in going long XLF, an ETF that tracks the financial sector, while going short TLT, an ETF on 20+ year Treasury bonds.

The XLF chart is pictured below; currently, the market is at 9.66, almost 100 points above its 52 week low at 8.67. Government actions may hold up XLF and lead to a rally back up to resistance near 13.20, another key price point to watch.

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