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Inflation Is A Constant

Below is an excerpt from Ed Bugos' Daily Global Market Outlook. For the full letter, and a free trial, send him email at: gold@goldenbar.com

We appear headed for another test of the $360 level on gold, as the dollar bullish environment on Wall Street extended yet another day.

The Dow continues to defy our bearish call, and surged another 116 points to close at 9039 Wednesday.

The bulls made a higher intermediate high intraday, but closed four points below December's (intraday) high, so I wouldn't call it a signal yet, even though it might be by Friday.

Moreover, key intermediate resistance is at August's (2002) high - 9077.

The odd thing about this rally is that the bulls are cautious. The headlines read "is this for real," rather than, "choo, choo, the train's leaving the station." Even Tom Gavin - whose remaining clients could well be hanging on to the stocks they bought three years ago - sees a pullback here, as well as a much less rewarding stock market environment going forward than was the case during the nineties.

Our sentiment indicators are mixed. Some are showing extreme bullish sentiment, while others suggest there is room for this sentiment to grow. None suggest too many bears.

The CBOE's put/call ratio suggests there's room for bulls to get more bullish.

The indicator set off an incorrect sell signal in April. Then a correct one a month later - in the middle of May.

But it was immediately followed by a buy signal - too many bears.

Since then, it appears bullish sentiment has been rising more cautiously. I don't know what's going to happen next.

The shorts might as well be careful here. The environment isn't unfriendly, but it might pay to wait out either a crack in momentum or a clearer reading from the sentiment indicators. In the near term, much may depend on the labor news this week.

Meanwhile, the bond market isn't letting up. Players could be acting out a little war anxiety, or they may be betting on a bad labor report, or they are bullish on deflation and the prospect of a Fed yield cap, or they're just momentum trading.

At any rate, whatever is driving the bond, the strength in the bond is driving stocks, higher. As for stocks, whether it's falling yields, or the falling dollar, or the recovering economy or profit boom, there is inflation everywhere at the moment.

That much we can all agree (defining it as too much money/credit) I hope.

Indeed, as long as it isn't perceived, yields can be managed. And as long as yields can be lowered, or kept low, stock values could rise further - at least until they approach full valuations (which we guestimate at about 1050 to 1100 for the S&P 500 today; don't ask what the other side of that range is).

I believe the falling bond yield is the single most influential factor in this stock rally thus far. So it shouldn't surprise you to see the Dow continue to rise so long as yields remain low, or fail to discount the true inflation picture.

And as long as it continues, it's bullish for the dollar.

My main outlook for the Dow is that the rally will end when yields spike, which I argue they'll do when the market begins to discount the inflation picture as we see it today.

But so far the stock markets continue to inch higher, with hardly an impact on bond yields. What gives? What's the rationale for buying bonds offering yields near 45-year lows when:

  • the dollar is reeling,
  • the budget deficit is soaring,
  • the trade deficit is soaring,
  • forward and trailing PE ratios for the S&P 500 are still near record highs,
  • gold is near six year highs,
  • commodity prices rose at their fastest pace in 20 years in 2002, and
  • monetary aggregates have been growing at their fastest pace in two decades

I can't stress enough that productivity alone can't sustain these RECORD bearish imbalances, or divergences. Neither can the historical record find many examples when during such conditions bond yields continued to fall.

So we have to look to unconventional explanations, such as the possibility of deflation, or manipulation, or the Fed's forecast use of unconventional tools, or even delusion.

Gold Stocks, Inflation, Yields, and the DJIA in the 20th Century
Gold stocks have been surprisingly strong in spite of the dollar's tiny bounce this week. Even Wednesday as gold prices fell, and the dollar recovered some ground against the Euro, Swiss Franc, Rand, and Mexican peso - it rose sharply relative to the latter two - gold stocks gained.

Newmont led the S&P gold sector index to a higher intermediate high, and now approaches last June's high at $32.75 for Newmont (and about 81 for the index).

They closed at $30.87 and 72.7 respectively, which are their best levels since.

Still, the picture was mixed in this sector Wednesday. Decent gains in the blue chips were offset by losses in the speculative end of the market.

Overall the charts of gold stocks aren't very telling. There has been an increasing bullish bias within the one year trading range most of them have been stuck in.

We were asked by a client to find some data on how gold stocks had performed during the seventies environment - which happens to be our model for the future.

So let's recap and define our model briefly.

First, we assume that inflation is a constant. There is no deflation in our model (which I think is reasonable so long as there is central banking, an overvalued currency, and in light of the evidence). There is only an ongoing currency devaluation occasionally interrupted by the consequences of an oversupply of commodities - after their prices rise too fast - which also often provides the conditions for a new monetary boom to take place.

Ludwig von Mises said in 1952:

For there is no doubt that what we have experienced over the last hundred years was just the opposite (of the general tendency for prices and wages to drop), namely, a secular tendency toward a drop in the monetary unit's purchasing power, which was only temporarily interrupted by the aftermath of the breakdown of a boom intentionally created by credit expansion - from the 1981 edition of the Theory of Money and Credit, pp. 457, The Principle of Sound Money, from section 2: the virtues and alleged shortcomings of the gold standard.

This chapter was written in 1952, several years after the original publishing of the book. The parentheses are mine.

This (interruption in currency debasement) was the case after WWI, after WWII, and after the seventies era of soaring prices ended in about 1982 (reference our earlier categorizations of booms and busts in the 20th century). I don't have clear 19th century data, but according to Mises' data, such cycles have apparently been the case since the 1850's.

In other words, each of the boom periods comes about "after" a sharp devaluation in the dollar has already occurred.

More specifically, our model assumes that said banking system grows too much credit, which is followed by a monetary debasement once the monetary boom fails to sustain any further increases in paper (stock and bond) values - at the margin - which then results in the rise of all remaining prices as the currency fails and the central bank remains committed to the credit expansion (i.e. as the prior boom busts).

Then, if the bank decides to abandon its loose policy, or after the currency has fallen too fast and commodities are overproduced, there is the opportunity for a new credit expansion to take root at a much lower plateau for the currency, which in time will give way to a new bust, and devaluation.

This is the history of our monetary system, so I don't see why we should abandon that model just because the new fad is deflation.

Note the long cycles for interest rates (yields) in the chart above.

Going back 200 years, according to data from Global Financial Data, the Treasury note has seen four bull cycles (yields falling) and three bear market cycles (yields rising) ranging anywhere from 15 years up to 40 years in length.

Theoretically, these cycles should match the boom-bust (credit) cycles outlined earlier, but in practice they are distorted between 1933 and 1966. Otherwise, the reality confirms the theory.

Thus, whether bond yields rise or fall depends on where the currency is in its repetitive cycle of devaluation over the long term.

When the dollar is in devaluation mode, it normally results in rising inflation expectations (as well as war by the way). And when the dollar is plateauing, if you will, it coincides with disinflation trends (and the peace dividend). But the whole time, the monetary aggregates are expanding, except for the odd deflation scare here and there.

Note in the chart below that gold stocks began to rise even in the 1950's (they rose in the mid thirties as well, but I couldn't get the actual data all the way back that far). Nonetheless, arguably the first meaningful wave in the subsequent 20 year bull market for gold stocks occurred from 1960 to about 1968.

Unlike the current gold stock cycle, which didn't get underway until after the Dow peaked in 2000, the market back then appeared to factor the inflation sooner.

Note in the chart above that the S&P PE ratio peaked by about 1961.

But for a small deflation scare as M3 slowed to a crawl in 1968, there was ongoing inflation, and yields rose to reflect it by then.

What was happening, according to our model, was that the credit cycle was breaking down. Gold and bond markets began to discount it. And by 1971, when the dollar was allowed to float, it proved those markets right by collapsing.

That devaluation announcement kicked off the second wave in the gold share bull market, and it coincided with a third run in the Dow to the old 1966 peak. But it ended after the Dow bottomed in 1974. The third wave began in about 1977, as the Dow and dollar failed again.

Some important observations include:

  • The entire bull market in gold stocks was marked not by a period of rising inflation, which was a constant, but of rising inflation expectations (implied by rising bond yields 1947-1981), and currency debasement
  • There is a strong inverse relationship between gold share values and broad market values (even stronger relative to earnings multiples)
  • There is a strong positive correlation between bond and broad stock market values (or between bond yields and gold share values)
  • The long term trend in prices and currencies reveals Mises was right about a secular dollar devaluation interrupted by boom periods - usually manifesting in credit expansions
  • The cycles in yields and dollar devaluations or plateaus last anywhere from 15 to 40 years - they average about 25 years (the current one is 20 years old)
  • The gold share bull market began after the major market peak this time around, while it began six years ahead of the sixties peak last time
  • The only two periods since 1959 where deflation was actually a threat were 1968 and 1992 - in both years, gold corrected, as it should (and as opposed to some of the popular arguments today)

If we used the seventies as a model for the most likely direction of the economy today - which I think is very appropriate - and assumed a similar devaluation in the dollar (and bull market in gold), the upside in gold shares is probably enormous. According to the extent of gains in the Barron's gold stock index back then, we could expect up to a 20-fold increase in the value of gold stocks on average over the next ten years or so.

Maybe the AMEX Gold bugs index will go to 1000. I don't know. For now, we'd be happy with 225. I think much depends to what extent the Fed can fool people from perceiving the inflation for what it is - a constant.

If you accept that equity valuations (as opposed to simply stock prices) have mostly peaked, and you reject the deflation model, the bulk of the evidence suggests that:

  • Gold stocks are on their way to higher ground (in their first wave so far)
  • The dollar will continue to devalue, and
  • The 20 year bond bull market is nearing an end

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