Preparing for the Fall

By: Bob Hoye | Mon, Sep 10, 2012
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In a world of uncertainty, in one sector there is a lot of certainty. The interventionist establishment remains confident that at some point their manipulation of rates of interest and rates of depreciation will achieve economic utopia. And then they will quit. Sure - and bulls always know when to get out.

Traders remain skeptical.

Austrian School economists remain certain that at some time there will be a "crack-up boom" - whenever and whatever that is.

Gold bugs remain convinced that central bankers can depreciate at will. In so many words, they can collapse the dollar to zero.

Financial history says that they can't.

As for myself, I'm only certain about two things that won't happen. They will never publish a book called Great Moments In Disco; nor one titled Great Moments In Macroeconomics.

To be serious, there is only one financial history and it repeats. A great asset inflation, otherwise known as a bubble, climaxes and collapses. While horrendous the transition from boom to bust has been methodical. That's on six examples from the "South Sea Bubble" in 1720, to the "Roaring Twenties" in 1929 and to "usual suspects" beginning in 2007.

These have been the greatest dislocations in financial history. All five prior to ours marked the beginning of a Great Depression that lasted for some twenty years. If the "Black Swan" guys were on the scene in the fall of 2 1720 they would have been surprised. At the time participants knew it to be an ephemeral bubble. Also in 1772, 1825, 1873 or 1929 the calamity would have been called a Black Swan Event. But, all the initial crashes occurred in the fall, and that is methodical.

Also methodical is that each bubble included a frenzy of borrowing short and lending long, of which the signature is an inverted yield curve. Then where data are available, typically a boom will run some 12 to 18 months against inversion and when the curve starts to reverse it signals the end of speculation. This provided a three-month warning to the end of the Dot.Com Mania in March 2000. And in 2007 the killer month for THE reversal in the credit markets counted out to June. The curve began to reverse in May and in that fateful June it began to be accompanied by widening credit spreads.

By early June these had clocked the trend change and the observation was that the "Biggest train wreck in the history of credit" had started.

It is not over.

Another feature of the post-bubble world has been severe recessions and weak recoveries. There is another methodical step as the recession virtually starts with the bear market. Usually the stock market leads the business cycle by around 12 months. Using NBER numbers the recession started in October 1873 and the crash started in that fateful September.

As credit stresses were building in the summer, a leading New York newspaper editorialized that the US Treasury System was superior to a central bank constrained by a gold standard. An excerpt from the editorial records the belief that the agency of the day was proof against contraction: "Power had been centralized in him to an extent not enjoyed by the Governor of the Bank of England. He can issue the paper representatives of a score or more of millions ... it is difficult to conceive of any condition or circumstances which he cannot control." In so many words, nothing could go wrong.

This is similar to Harvard economist Greg Mankiw's beliefs. In December 2007 he boasted that nothing could go wrong because the Fed and the White House had a "Dream Team" of economists. Eventually, the NBER decided that the recession started in that fateful December. It became the worst recession since the 1930s.

What else would one expect.

Late in 2009, and not noticing the irony, the establishment began boasting that without the stimulus that crash would have lasted forever. This contrasts with the boast that nothing could go wrong. The notion that markets don't clear exists only in textbooks.

The post-1873 example provides further instruction that can't be found in textbooks. As the economy was suffering its second and severe recession in 1884 senior economists began to call it the Great Depression. It lasted from 1873 to 1895 and was still being analyzed as the Great Depression until 1939 when economists discovered a new one.

Another unsupportable econo-myth is the notion that a Fed cut will keep a boom going. Short-dated market rates of interest go up in a boom and down in a bust. And the most dramatic declines only occur during the initial post-bubble crash. In 1873 the discount rate at the senior central bank plunged by 650 basis points. During the 1929 crash the Fed cut the discount rate by 450 beeps as was the case in 2000 and in 2007.

I guess that the "Dream Team's" plan was to cut rates to keep the boom going.

Throughout the Fed's history at important tops and bottoms changes in the administered rate have followed changes in market rates by 2 or 3 months.

So why listen to policy announcements? Moreover, at disastrous turning points in the credit markets it has no, repeat no, influence on the yield curve or credit spreads.

The Fed is all show and no go.

There is a reason for this, and it has to do with an old saying in Physics: "If you keep your data-base short enough it will fit your theory". It seems that most any crash will prompt an intellectual to have a personal revelation on how to fix the hardships of a bust. On the other hand, traders with experience as in a long data base learn to get out and get short. Traders, such as Gresham in 1551, knew that nothing can be done about a credit crisis.

One of the earliest of impractical revelations was made by Edward Misselden in the 1618 to 1623 crash. That was an important one as it was one of the steps that Mother Nature took to end a hundred years of deliberate price inflation.

Since the 1500s there seems to be two kinds of comments about interest rates. One type is the complaint that someone, or some agency, has set them too high. The other is the dream that some agency can willingly set them low. Treasury bill rates are at Depression lows. Set by market forces, not by central bankers.

At the height of the 1873 Bubble, Walter Bagehot, the highly regarded editor of The Economist wrote that a financial crisis was a form of "neuralgia" that could be banished by appropriate employment of central bank credit. As mentioned, the 1873 to 1895 post-bubble contraction was called the Great Depression.

Moving right along, Bagehot's notion about discounting liberally during a crisis was likely known by Fed and Bank of England staffers in 1929.

Although recent scholars of the early 1930s claim that the whole disaster was due the Fed being "stupidly" tight, newspapers of the day show something else. Revisionists state the Fed increase to 6 percent in August 1929 "caused" the crash and that "caused" the Depression.

With the rate increase The New York Times explained that the Fed was tightening funds for Wall Street while easing funds for Main Street.

During the crash the New York Fed bought bonds out of the market - and exceeded its authority by a factor of six times.

Fortunately, in 1932 Barron's provided an indelible summary of the Fed's efforts to provide liquidity: "The Federal Reserve policy of cheapening credit through the purchase of government bonds has been unable to make a dent in the conservatism of borrower or bank lender, in short, every anti-deflationary effort has yet to provide positive results. The depression is sucking more and more bonds into its vortex." The reason this is not in the textbooks is that the Federal Reserve is the perfect system. Proponents of central banking have to insist the guys running it were stupidly tight.

Who are you going to believe.

Newspapers of record of the day, or ambitious academics forty years after the crash.

Gold's behaviour through a financial mania and its disquieting consequences has also been methodical. Typically gold's real price sets an important low in the year the bubble climaxes as base metals set high real prices. Then, with the general contraction, the gold sector trends up until the Great Depression completes - some twenty years later.

While the post-bubble world may be the worst of times for base metal miners, it is the best of times for gold miners and exploration companies.

This has huge influence on stock prices. From 1927 to 1929, International Nickel soared from 8 to 72 as real base metal prices increased. On the other hand, Homestake only rallied from 7 1/2 to 11 1/2. Mainly because gold's real price was going down - and so were Homestake's earnings - from 73 to 52 cents.

One of the recent concerns of the gold community has been that in 2005 gold stocks broke the pattern of moving up with gold's dollar price. History provides an explanation. Gold stocks were dull compared to the incredible action in base metal miners. SPTMN is the index and in the final two years of our bubble it doubled the gains in golds - because real prices for base metals soared while those for gold declined. Ironical because the dollar declined as part of the mania.

Nothing new or strange in this.

Rising real prices for gold also enhance the worth of gold discoveries and while there is plenty of 1930s history on the seniors, there is very little on the juniors. In the early 1970s I attended a promotional meeting on a stock.

Can't remember what it was, but the older and dapper gentleman who introduced the "great" promoter had been a broker on the wild Montreal Exchange in the early 1930s. When I asked him if the juniors had been hot then, he said "Sonny, in 1933 my best customer gave me a brand new Ford Roadster - as a thank you." Gold's methodical nature generates some fascinating numbers.

On the 1825 to 1844 Great Depression gold's real price (deflated by the CPI in the senior currency) increased by a factor of 1.63 times.

On the 1873 to 1895 Great Depression it increased by a factor of 1.69.

On the 1929 to 1946 Great Depression it increased by a factor of 1.70.

Naturally this inspired dramatic increases in gold production. But while the price increases were remarkably similar - production increases were not.

On the depression that ended in the 1840s the annual rate of gold production soared 450 percent from 14 tons to 77 tons. A few years later the number was 187. California discoveries were very exciting.

On the depression that ended in 1895 production increased 107 percent from 147 to 305 tons. In a few more years it increased to 462 tons annually.

Australia and the Klondike were very exciting.

One message is that the great gold rushes occurred at depression bottoms when the real price was high and so was global unemployment.

World War Two did not alter the price increase but it prevented another great gold rush. But from 1929 to 1940 annual production only doubled.

The other message is that the same price increases do not prompt similar increases in production. This suggests that trying to determine price from analysis of supply and demand may be frustrating.

All one needs to know is that the real price, profitability and annual rates of production will increase substantially over the next twenty years. Of course, the usual business cycle will maintain, but if the past continues to guide gold mining will become the premier sector as most industry and commerce suffer pricing pressures.

As the calculation of the US CPI became suspect it has been appropriate to use gold's price divided by our commodity index as a proxy for the real price. It also is a forecasting tool. It declined to 143 in May 2007 and turned up three weeks before the credit market started to crash in that fateful June.

It soared to over 500 in February 2009 and turned up some three weeks before the panic ended in March 2009.

In last fall's panic it soared to just under 500 and with recovering spirits in orthodox investments such as stocks, garbage bonds and commodities it declined to 404 in July. The uptrend was set this week and it is anticipating another liquidity crisis.

Another reliable indicator with a long history is the gold/ silver ratio which goes down in the good times and up in the bad times. At extremes it acts like a credit spread.

Under Great Britain's remarkable financial discipline after the insanity of the 1720 Bubble until the next insanity in the early 1800s, the ratio stayed around 15. In the 1825 Bubble it was at 15.8 and at the depression bottom of 1844 it increased to 17.2. At the end of the next depression in 1895 the ratio reached 34.

The long term trend has been that the gold/silver ratio increases with each Great Depression and it reached 91 with the distress that concluded in the 1940s. Moving right along it reached 84 with the 2008 Crash.

Then with the good times the ratio dropped to 32 a year ago in May, and was extremely oversold.

For making a timely market call it has been useful to look at the ratio upside down. On any rally for precious metals silver will outperform gold and silver really did it on the last big rally. Momentum was spectacular as the RSI reached 92 in a April a year ago. This matched the high reached in January of 1980.

Clearly that was a lot of bullishness that needed to be wrung out of the markets.

The plunge in gold stocks from May last year to May this year ended with the second worst oversold in over a hundred years. Using the monthly RSI the worst was in 1924 and others almost as bad cleared in in 1942, 1948 and in 2008.

This May's abysmal low needed testing and the test was severe and completed in July. On momentum and sentiment an important bottom was set. It could survive this fall's liquidity problems when conditions would be then be set for a major advance in gold's real price and the whole gold sector. Think about exploration stocks and Ford Roadsters.

Although it is a long way from a powerful market, there is a reliable indicator of the final blow-off. The inevitable mania will be close to peaking when young operators start promoting that old property in Nevada that has so many holes in it that when the wind blows it whistles.

Back to the bigger picture. Not only does gold set an important low in real terms as bubble concludes, but so do real long-dated interest rates.

Whether the senior central bank has been on gold or off, a bubble creates a lot of money and credit that drives nominal yields down as stocks and commodities rally. The result can be minus real rates as in 1873 or 2008 or only slightly positive as in 1929. In the consequent contraction real long interest rates in the senior currency have typically increased by 12 percentage points, repeat 12 percentage points. In the initial collapse in 2008 the increase was a severe 6 percentage points. The next collapse could accomplish more than that.

This effectively ends the abuse of credit markets by private participants in Wall Street and by financial adventurers in central banks - otherwise known as a new financial era.

The post-bubble relentless rise in gold's real price has been equally transformative. This time around, the rise will become irresistible to even senior central banks and they will want to have more of it in their reserves.

It will be interesting to watch how they change their theories to rationalize owning a winning ticket.

With this statement inquiring minds may wonder what drives the real price up. Every bubble takes on more debt than the global economy can service.

Recently Steve Hanke noted that private credit is contracting faster than policy makers can expand government credit. Another feature of a bubble is that it not just an extraordinary expansion of normal credit instruments, but a bubble of innovative credit instruments as well.

These contrast in what can be called a great bond revulsion that is part of a credit vacuum. Mother Nature can't tolerate a vacuum and starts to raise gold's real price, producers respond and increase rates of gold production and that, despite central bank intolerance to gold, begins to re-liquefy the global banking system. It usually takes some twenty years to build to the next party era.

Does that make me an optimist? Only on the very long term. Near term, I'm cautiously pessimistic.

The theme of this Summit is "Navigating the Politicized Economy".

Well, the first decision is to get political intervention out of everyone's life.

Its only point has been to obtain a living from some else by messing up their lives. This could start by getting even with the confiscatory predators who have politicized the economy. Sell all their bonds and don't buy any new issues until they discover fiduciary responsibility. "They" being governments around the world including US munis.

That'll be a lesson to them! We started this in May when we got out of our long-dated treasuries.

Actually, it was on a huge technical "Sell!" signal, that was followed in July by similar calls on investment-grade corporates and then on emergingmarket debt. Historically, the 12-percentage point increase in real long rates could be starting and this will eventually get the predators. But we can have some fun by being Bond Vigilantes along the way.

The next step is to ridicule interventionist economics. There is no there, there. The body of interventionist theories and practices is based upon personal revelations that some agency can raise or lower interest rates at will. As noted earlier, this superstition dates back to the 1500s, at least.

The naively popular notion that throwing credit at a credit contraction will make it go away is about to be disproved - again.

Revelation denies empiricism, every time and its worse - there is no logic.

Take the idea that a state-sponsored credit expansion will cause a business expansion, extend a recovery or in 2008 keep a panic from running forever.

Unfortunately, this is an example of the dreaded primitive syllogism. Scary phrase isn't it, but the most used example is that roosters crowing in the morning cause the sun to rise.

Business and credit do expand together, but one does not cause the other.

The only reason such nonsense became dominant is because it provides the means to fund the state through currency depreciation. Recently the US experiment in authoritarian government has turned unusually ambitious and we all know that unlimited government requires unlimited funding. Many think that the Fed has the ability to do this through equally ambitious depreciation.

Promises about printing presses and helicopters come to mind, but market forces have something else in mind.


The real price of gold has turned up and that typically signals the onset of liquidity concerns. This melancholy probability will be confirmed when the silver/gold ration turns down. This week, on Thursday momentum reached 85 on the RSI which is in very dangerous territory. The 92 accomplished in April 2011 was in extremely dangerous territory.

On the positive side, the next crisis will provide an outstanding buying opportunity in the precious metals sector.

The title of this address, "Preparing For The Fall", has trading opportunities in mind as well as something more profound. And that is what will happen to the cult of policymaking and central banking with the onset of another banking calamity.

First of all, financial history provides a severe due diligence on every grand scheme ever floated in a mania. That used to be limited to private promotions. But with the corruption of policymaking by a couple of generations of financial adventurers, the severe due diligence will include central banking.

In which case, history also provides a "Dream Team" with formidable powers to shred the nonsense of a national economy that can be managed by economists who seem to acquire a unique genius when appointed to the Fed.

The "Dream Team" is Mother Nature and Mister Margin and this fall they will be joined by the public's discovery that all that taxpayer "stimulus" is not working.

By way of closing, I'll pass on something timely from the old and dreadful Vancouver Stock Exchange and that is the definition of a promotion: "In the beginning the promoter has the vision and the public has the money." At the end of the promotion, the public has the vision and the promoter has the money." I'll leave it to this audience to determine who and what has been the greatest promotion in history.

Thank you.



Bob Hoye

Author: Bob Hoye

Bob Hoye
Institutional Advisors

Bob Hoye

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