Wednesday, October 13, 2010

Gold vs. Treasuries - which to believe?

Gold vs Treasuries - which to believe?
By Michael Pento

Any psychoanalyst looking at the behavior of investors today would see clear strains of schizophrenia in a comparison between the markets for gold and US Treasuries.

The 10-year Treasury yield is setting new lows on a daily basis. In the financial models all economists were taught at school, this would be an indication of an economy with low inflation expectations and a strong currency. But the dollar has fallen over 12% since June, and the price of gold continues to hit all-time highs. These results are completely antithetical. Bonds are flashing a warning sign of deflation, while gold and the dollar presage hyperinflation.

During the last period in which the US experienced significant economic stress, the late '70s and early '80s, the markets in gold and Treasuries showed a much higher degree of harmony. At that time, the Fed's extreme depression of interest rates led to rapidly rising inflation, a weakening dollar, and a spike in the
gold price. More significantly, yields on Treasuries soared as investors demanded higher rates as compensation for the added inflation risk. In other words, everything made sense.

Beginning in January 1977, gold began an epic bull market which ended just prior to February 1980. In that time, the metal soared from $135 per ounce to just under $860 per ounce, and the Dollar Index lost about 20% of its value. Yields on the 10-year Treasury soared from 7.2% in January of 1977 to 12.4% in February of 1980. This occurred in an environment where the Federal Reserve - under Arthur Burns - pursued an inflationary monetary policy. He increased the monetary base to $114 billion from $62 billion in just eight years.

Today, the environment is similar to what the country confronted 30 years ago. Like then, our monetary base has surged - but this time even faster. Instead of merely doubling in eight years as it did under Burns' watch, former Federal Reserve chairman Alan Greenspan and his successor, Ben Bernanke, have tripled the base in 12 years (to over $2 trillion today from $621 billion in 2000). Accordingly, the dollar price of gold has more than quadrupled, from $280 per ounce in 2000 to over $1,300 today. Over that time, the dollar has registered a 35% drop in value. However, in stark contrast to 1980, the yield on the 10-year Treasury note has collapsed from 6.6% in 2000 to less than 2.4% today.

A nation should only be able to enjoy ultra-low interest rates if it has a high savings rate, stable monetary policy, low inflation, and very low levels of debt. The US
savings rate, which had been range-bound between 7.5% and 15% during the '60s and '70s, now stands at just 5.8%. And that rate reflects recent belt-tightening in the wake of the credit crunch. The personal savings rate had been negligible and sometimes negative from 1998 through 2008. Washington's current annual budget deficit is 9% of gross domestic product (GDP) and the national debt is 93% of GDP. And, of course, the Fed has - in its own words - undertaken "unconventional measures" to push up inflation. Therefore, none of the conditions that should engender low interest rates currently exist.

Clearly both gold and
the US dollar agree that Bernanke will be victorious in his quest to foment robust inflation. But Treasury investors seem to believe that despite its current inflationary disposition, the Fed will be able either to: a) hold down interest rates for an extended period; or b) withdraw its liquidity before things get out of hand. To take this position, one would not only have to believe that the forex and gold markets have it wrong, but also think that the Fed's printing press will lose its power to depreciate the currency. This is a seriously misguided set of assumptions....
The FED and Bernanke are utterly corrupt, bluffing the World...

Bernanke asserts that the Fed brought on the Great Depression by allowing the money supply to contract by 30% after the Crash of 1929. He has also written that the depression relapse of 1937 stemmed from Washington's attempt to balance the budget and raise interest rates. Therefore, I can reasonably assume that he will not stop the presses until inflation has a firm and undeniable grip on the American economy.

Many believe that "Helicopter Ben" has yet to ignite inflation on the ground because the money he dropped from the sky is still stuck in the trees. In other words, the funds are caught in the banking system and not spreading among the populace. Yet, the M1 money supply measure is up 6.2% year on year; and, in the past two months, the compounded annual rate of change in the broader M2 is 7.4%. Although these single-digit increases do not yet indicate runaway inflation, a program of relentless quantitative easing has a conclusion as predictable as driving 100mph around an icy mountain turn. Since the Fed chairman has shown no will to hit the brakes, you'd have to be mad to ride the yield curve alongside him....

BRNANKE, Print, Print and Print"

Dr. Marc Faber[Ed. Note: The following is an extract from the October edition of Dr. Faber's indispensable monthly newsletter, The Gloom, Boom & Doom Report.]

No matter what central bankers and the cheerleading, mostly useless academics who surround them pronounce in their self-created aura of infinite academic "delicacy and refinement", under the auspices of the Fed they will do precisely one thing: print, print, and print. Sadly, as Mignon McLaughlin observed, "The know-nothings are, unfortunately, seldom the do-nothings."

I should like to emphasize once again that the US Fed will continue to monetize massively on any sign of either further economic weakness or a more meaningful (10% or so) financial and property market decline.

In the world I described above, the increased supply of dollars will flow somewhere.

Recently, CNBC interviewed 81-year-old Bernie Marcus, one of the founding partners of Home Depot. (He was CEO between 1979 and 1997.) Marcus, who is a self-made man and completely level-headed and without arrogance of any sort, described how he and Arthur Blank (the other co- founder) struggled when they opened their first store in 1979, in Atlanta.

For example, at 10 pm on his 50th birthday, he said, he was still in the store, moving boxes around without air-conditioning, because they needed to save money. He then said that he doesn't mix with "important people", such as Jeff Immelt of GE, and smooth-talking bankers and academics; instead, he talks daily with small businessmen, which is what he was when he started his business. He then cited several examples of people who run small businesses and who had told him how difficult business conditions were. He suggested that, like the king in a fairytale, Mr. Obama should dress up at night like a pauper and go out and talk to business people. According to Marcus, King Obama would then realize how unpopular he is and how destructive his economic policies have been for small businesses. He also suggested that the academics at the Fed and in the administration should, for once in their lives, go out and work, instead of sitting in big glass office towers and having no clue about what is ailing the economy.

Marcus then emphasized that none of the small businessmen he talked to had any plans to hire staff, because they felt there was far too much uncertainty about what kinds of regulations and laws Congress and the administration would come up with next. All his business friends and customers had told him that Obamacare would be a complete disaster for them. (It imposes on small businesses enormous non-medical tax compliance. It will require them to mail IRS 1099 tax forms to every vendor from whom they make purchases of more than US$600 in a year, with duplicate forms going to the IRS. Obamacare will also fund 16,000 new IRS agents...) Asked what he would suggest as a solution, Marcus, who looks much younger than his age and is still very alert, responded that the US would be greatly helped if Congress went on a holiday for two years, as this would prevent the government from doing even more economic damage.

I have mentioned on previous occasions the critical views of other businessmen, such as Lee Iacocca (formerly of Chrysler) and Paul Otellini (CEO of Intel). Like Marcus, their view is that regulation is stifling capital spending and any employment gains in the US. But, whereas the "Otellinis" of this world are more in touch with large corporations, Marcus - whose philosophy is: "Whatever it takes" - is cultivating relationships with a vast number of ordinary people who run their privately owned businesses and have sales of from half a million to 100 million dollars.

Marcus was also very critical of the various financial bailouts (unlike the self-serving and hypocritical Charles Munger). But one point he made was particularly interesting. He said that the business people he talked to had access to credit; that banks were willing to lend them money! But they had no interest in borrowing funds given the current regulatory uncertainties. I should mention that Marcus is the antithesis of economic policy decision makers and academics who imagine themselves to be of infinite delicacy and refinement and suffer from "a narrowing of the mind" - not because they travel, but because they have never in their lives worked in a real business. But, obviously, he knows what he is talking about. (Home Depot now employs over 300,000 people.)

Now, does anyone really think that, under the conditions Marcus has described, the Fed's increase in the quantity of money will flow into US employment and real wage gains? As Marcus likes to say, "You must be kidding!"

The money flows will continue to boost employment in emerging economies, along with their wages and asset prices.

The best way to visualize this process is to think of a huge money- printing machine in the US that produces an unlimited quantity of dollars. Most of these dollars flow to the corporate sector, financial institutions, and wealthy individuals. A large proportion of these dollars is then transferred to emerging economies through the US trade deficit and investment flows, and boosts economic activity and increases wealth in emerging economies relative to the US.

Some of these dollars then find their way back to the US and support Treasury bond prices. But since fewer dollars find their way back to the US than exit the country, the dollar has a weakening tendency against emerging market currencies and, especially, against hard assets whose supply is extremely limited compared to the money that the money machine keeps spitting out....

Failure of IMF meeting was preordained with Western countries ganging up on China.?

The failure of IMF meeting was preordained with Western countries ganging up on China and sole subject seemed to be yuan’s value and China’s massive ever-increasing forex reserves.

G20 meeting is NOT going to solve this trade imbalance problem any more than IMF meeting could or WTO could or DOHA could.

There is as such NO solution to this waxing but huge problem except for countries suffering from China’s massive trade surpluses with them, to discard WTO and start looking after their own interests by erecting old-fashioned trade barriers.

US and EU, the biggest losers in trade with China can coordinate their efforts to force reduction in China’s exports to them.

China will retaliate by imposing its own trade barriers.

There will be a period of recriminations back and forth.

There will be inflation in US/EU and unemployment in China. US/EU can further loosen their monetary policies and China can use its massive forex reserves to cushion the impact.

But ultimately China may be forced to let its currency float, thereby bringing some balance to world trade.
Otherwise there will be another great depression, this time the real one with no cure in sight....

March 2011....

In Canada, gold stocks have been lagging the price of gold from the start of the gold bull market in 2002 (they were quite lively in later 2003, from May 2005 - May 2006, and of course after the October 2008 crash, but that's about it!).

Of course, the Canadian dollar has run up from $0.62 US to $1.03 US during that same period (a trend that will continue for most of this decade). That is a 66% gain - no small headwind against the US dollar gold price! (Unfortunately, I can't chart the SPTGD Canadian Gold Miners Index against Canadian dollar gold, or I would!)

However, even when we look at gold mining stocks in US dollar terms, we still see a decline in the ratio of the stock prices of gold miners (the HUI "Gold Bugs" index) to the price of gold from 2003 onward.

What's wrong with this "ratio" decline? I can tell you - gold miners' profits are rising faster than their costs, due to the now 10-year long gold bull market - but the miners are losing in value against gold, whereas rationality tells us that they should be gaining as their margins inexorably rise!

Consider too that gold has been quite strong - more than sufficient to cover rising costs - in Canadian dollar terms as well, as seen below (Canadian dollar gold had risen from $390 to $1405 as of March 7, 2011):

Is the market therefore irrational?

My gut response is to say, "Yes, absolutely - this downtrend in gold mining stocks relative to gold is totally crazy!"

However, as we have discussed here many times, this is just the "wall of worry" that all bull markets climb. In fact, I'll tell you exactly what is happening. Gold has been gaining in price for 10 years - and it has at least 7-9 (and perhaps many more) years to go.

However, every time gold makes a new high, the broad majority of investors start to prepare for the possibility that "the top is in." Then when gold sells off even $10-$20, due to normal market fluctuations, they unload the gold stocks they had bought a few days or weeks earlier. On a daily or weekly basis, this pattern of fluctuation looks like noise, but as you can see on the long-term charts above, the market is now dramatically underpricing the stocks of global gold mining companies (60% of all mining companies are listed on the Canadian exchanges).

That is, everybody knows this is a 10-year bull market, but the great majority entirely lack confidence that it will be an 11-year or 12-year bull market, let alone a 17 to 18-year bull market (which is typical of such cycles), or perhaps a 2 to 3-decade bull market, as we have seen recently in bonds - which surely are topping out somewhere about now.

Take today's action as another example of that consistent pattern. Only yesterday, gold made a new all-time record high of $1444.40. However, today it sold down to as low as $1423.40 (a $21 decline, but from a record high level!).

What then happened to the gold stock sector? Let this come as no surprise to you - gold stocks were smashed, with both the HUI and SPTGD gold stock indices losing over 1%. Hey, and what happened yesterday? Oh, the same thing. On that day, gold sold at the highest nominal US dollar price it has ever commanded in history - and the stock prices of gold mining companies sustained losses of about 1.5% on both the US and Canadian exchanges - greater than their losses today!

Again, on a daily basis, this looks like noise. but it actually represents a cumulative 9-year downtrend in the market price of gold mining companies relative to the soaring price of the commodity they sell at ever-increasing profits - gold!

If the market is indeed irrational, as demonstrated above, will it then correct at some point for such obvious mispricing of gold mining companies?

You betcha!

If history is any guide, the odds are 99.99% that the answer is "yes." At some point, the market will price gold stocks rationally - and then, more confoundingly still - it will go on to over-value them!

So what am I claiming here?

Basically, I am stating that markets are in fact 100% rational - just not in terms of their daily behaviour, which over time may accumulate to periods of years and - as we see in the present example - decades!

What then are the lessons?

Pretty simple, actually.

Investors who hold on to gold mining stocks at today's prices will virtually certainly see fabulous gains at some future point, probably still several years in the future, as gold stocks move from being undervalued to being rationally valued, and then to being overvalued.

Sounds crazy?

Hey, this is human nature we are discussing - cumulative human psychology if you will! This is just what humans do. All the charts are doing is reflecting our own behaviour back to us - bizarre though it may be!

Based on historical trends, gold stocks are likely to be fairly valued (again) a few more years forward - perhaps as soon as 2012, based on multi-decade patterns of strength and weakness in this particular sector, which have been identified by Pamela and Mary Ann Aden.

Then what? Well, a few years further out, the market will over-value gold stocks, and then it will be time to sell them - but by my reckoning, that period of over-valuation will not occur until near the end of the present decade - or perhaps even later.

In fact, the consistently negative relative price action of the past decade has been very bullish for gold stocks!

Why is that?

Basically, contrarian psychology is at work here. After ten years, it should be quite obvious to essentially everyone who is paying attention that gold is in a sustained bull market.

As obvious as this sounds, the great majority of investors do not yet perceive this. They view the entire period to date as an anomaly - a mysterious or irrational trend that at any moment is likely to reverse.

After 10 years, you might think that such twisted logic would no longer be persuasive. Yet one need study the price action in gold and gold stocks over only the past two days to see that the same pattern which has kept gold stocks undervalued for a decade is persisting at this very moment!

Here's the funny thing about markets though - and all investors who have studied history know this - the present pattern of pricing gold stocks will not end until it has turned around to its opposite.

That is, to anyone with historical awareness, the recent top in the gold price ($1444.40) cannot possibly be the top price in the present trend, because the market is still undervaluing - vs. overvaluing - gold mining companies.

Historically - these two patterns have never occurred at the same time. That is, the gold market can "top out" only when gold mining stocks have become overvalued. There is no precedent for such an occurrence at a time when mining stocks are under-priced relative to gold, particularly while still in a 9-year relative downtrend!

Again, reversals at junctures such as we see at present simply do not happen - ever!

(To be clear, I'm not saying that we will necessarily ever recapture the ratio highs of 2002-2003 - or that gold mining shares can't randomly fall quite a bit below where they are priced today. Rather, I am discussing larger patterns. What I maintain is that the bull market in gold stocks can end only when gold stocks are over-valued, that is, when they are in a sustained uptrend relative to the price of gold. Such ending patterns have no resemblance whatsoever to the pattern we have witnessed for the past 9 years!)

History teaches an incontrovertible lesson. No sectoral bull market has ever ended with stock prices at undervalued levels. All bull markets end in overvaluation - every one, every time! And again, if history is our guide, no commodity has ever advanced for ten years and then reversed while the shares of companies that produce the commodity were lagging in price. This just plain does not occur - ever!

Now, that is about as close to a golden guarantee as you are ever going to get that the present bull market in gold has years to go, even if on many days gold stocks fall off a cliff when we see price declines in gold itself of $10-$20 or more - even when those declines follow record highs!

As has been said, "Don't sweat the small stuff - and it's all small stuff!"

What's the big picture here?

This is a bull market in gold, and at some point mainstream investors will wake up to this fact and drive the prices of gold stocks much higher than they are today.

And, if you're holding gold stocks already?

Just relax and take the ride.

It may be bumpy, but the ultimate direction is always up in markets of this type.

It is your golden guarantee!

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