This article was originally published for the benefit of subscribers on November 4, 2007.
The story of "Goldilocks and the Three Bears" initially began with a cute little girl having golden hair curiously walking into the house of the three bears and being scared out after a rude awakening. The new and revised economic version of "GOLDilocks and the Three Bears" is somewhat different. The modern version goes something like this: GOLDilocks (AKA gold) walks into the lair of the three bears (AKA Nasdaq, DOW and S&P 500 Indices in a bear market, yes, the pun is severely intended) and scares them out. The things that GOLDilocks "did" to metaphorically make them leave their lair are discussed below. The traditional view of the Goldilocks economy is being rewritten during these times.
The big news last weekend was CitiGroup temporarily withholding dividend payments and having an emergency meeting to determine how to correct or "cover up" any derivative problems. Up here in Canada, we might think we are immune to the derivative scandal, but the Ontario Teachers Pension Fund, the Quebec Pension fund (others I have not been able to find much more information about) and some Canadian banks such as BMO have some involvement in the bad credit many US banks spread around the globe. BMO is reported to have the largest exposure to the US SIV market than any other Canadian bank. Apparently, BMO raised 22 billion in August to strengthen their balance sheet in the event that any "problem" may arise. It appears that Canadian banks are much more conservative than the US banks south of the border that would grant loans to immigrant workers who lied about their income. Granted, there will be some pain, but the solvency of banks up here in the Great White North are likely to be well ahead of the curve with respect to many US banks that are set to implode.
The US government is going to have to issue bags and bags of credit in order to wipe out the derivative losses that will dilute their currency even further, which in turn will drive gold much higher. This has created an environment that is unfavourable to traders. While the HUI and gold are extended, things in a bull markets can become extended beyond belief, thereby making trading risky as the move advances without a significant correction. For this reason, we have been suggesting that investors continue to accumulate positions slowly rather than dump everything they have at once. We saw a 3 plus year correction in the HUI that stretched the oversold condition to an extreme. By idiot market makers trying to manipulate the price of something, it may work in the short-term, but it will come back and bit them four times harder when the trend reverses.
Prices of gold and silver have been suppressed for the past 10-15 years to the point that global production has been declining YOY with global demand increasing. Everything reaches a point where there is not enough supply to meet demand and from that point forward, the trend reverses in favour of those producing the item i.e. gold and silver miners. Historically, platinum makes the first move, followed by gold and then silver as inflation begins to pick up. Gold has made a move, but silver is still lagging...this is about to change over the course of the next 12-24 months. The gold/silver ratio hit 16 in 1980, with record amounts of silver stockpiled and currently is fluctuating between 50-55. At present, around 600 million ounces of silver are mined each year, with demand around 800-900 million ounces. This translates into stockpile depletion, which at some point are going to be completely wiped out. Many different pieces of electronic wizardry cannot function without silver, as there is no substitute known at present. As such, once shortages occur, many electronic companies are going to have to stockpile huge quantities of silver in order to ensure they can produce their products.
When companies start to hoard silver, the price will rise dramatically, which will in turn cause hoarding amongst people who will want to protect their own assets/play momentum. There is a record short position for silver, which at some point is going to cave in and put many of those institutions shorting it out of business. The silver ETF's are likely going to find owners going into empty vaults filled with IOU's...there are some honest holding firms and out there (James Turk is probably the best known source of buying e-gold on the net), but if it is with Goldman Sachs, CitiGroup etc., buyer beware. For those who do not own any gold or silver bullion at present, it is suggested to have at least 10-20% of net worth exposed. At present, the Royal Canadian Mint is around 3-4 weeks behind in their ability to deliver bullion bars to market. In the next 12-18 months, this time frame is likely to double or triple. As the delivery time is extended further into the future, this will translate into much higher prices e.g. Imagine having to put an order in for flour or eggs at a grocery store 3-4 weeks in advance because of a shortage.
Some may ask "how far are we into the inflation cycle?" and I would reply "We are just getting started". We have peak oil which in itself is going to spur huge inflation into the global economy over the next 4-5 years. Because of the modern age of Internet, the lines of 1980 for purchasing gold and silver will be moved online. However, lineups will be around for those who pick up their orders.
The only way governments of present combat inflation are to raise interest rates to slow down the economy (heaven forbid they were to stop printing money altogether to remove the cause). The US at present does not have the means going forward (at least the US government views it that way) to raise interest rates to slow inflation and support their currency. The easiest way to stop inflation would simply be to stop printing money but at present, this approach would collapse the global economy as a whole, since most nations are participating in this grand experiment. So rest assured, Central Banks around the globe are going to print money like there is no tomorrow in order to prevent a collapse in their economies. Other countries are not likely to experience inflation to the same Degree as the US, but rest assured, it will be felt.
Gas shortages at pumps, violent riots, food shortages, high unemployment, sky high gold and silver prices and last but not least, high interest rates are going to be required in order to bring this cycle to an end. To transition from the start of a bull market to the final throws, the populous as a whole must first go through the following psychological stages:
- Ignorance ("I don't see anything or hear anything")
- Denial ("We do not have a problem here, things will only get better")
- Opposition ("I do not like the way things are going, I am going to keep my dollars in the US and not buy gold or silver to help us out...why is the world doing this to us?")
- Tentative acceptance ("Damn, this gold and silver bull market has been going on for some time now, my neighbour seems to be relatively comfortable with his recent purchase of GoldCorp at $80 Canadian/share")
- Slavish acceptance ("My friend told me about some new company that has a prospective 3 ppm gold over 100 meters...gee, the lineup for picking up my gold was longer than one month ago and they may not even be able to deliver my gold for another month. I think I better order more tonight for pickup in 2-4 months because the supply is only going to get worse...heck the gold I picked up at $2000/ounce is now worth $3000/ounce")
Once we have passed through the psychological phases above, the bull market in gold and silver (the entire commodity bull market cycle) will be at an end. Ignorance persisted from 2002-2005, with denial (it ain't only a river flowing through Egypt) taking stage from 2006-early 2007. Recently, 2007 has been witness to falling home prices, higher oil prices and more expensive trips to the grocery store creating the psychology of "Opposition". This is the most oppressive phase and is the hardest nut to crack in the transitive series of psychological responses, because it lies right in the middle of the balance scale: Denial and opposition on one side and tentative and slavish acceptance on the other.
After this cycle ends, I think we are going to experience a severe deflation, followed by a massive re-inflation that will cause a secondary hyperinflationary wave to occur. Owning government bonds cash (40% of holdings) in stable countries and bullion (retain 60% of holdings) will be recommended after this cycle unwinds in 5-6 years, but it will be a for a 2-3 year duration only. After deflation hits hard and with aging baby boomers and a decline in global GDP due to a lack of energy, governments will still likely print money like there is no tomorrow. This will "re-ignite" the hyperinflationary fire causing one final blow-off for the global economy. It will be important to own "things" during this period, particularly farmland, gold, silver, heating oil and wooded sections of land because these will be the things that will give individuals some "bargaining chips" for survival going forward. All civilizations of the past collapsed once they went beyond the carrying capacity of their output. Peak oil is going to prevent economies from running at full steam and will lead to declining GDP...the only way countries will be able to keep %GDP increasing YOY will be to have expanded inflation to offset the economic decline. In the end, a severe bout of deflation will ultimately take hold and grip the globe, but this is anywhere from 5-10 years away.
One important item to identify where anyone is at any point in time, whether it be traveling across a country or traveling through the markets is an established "reference point". Reference points are important for determining where one is and the path they are headed. If one looks back to the 1966-1982 period, the major market indices were in bear markets, which hung that psychology on pretty much all market participants. It is important to note that most gold stocks actually reached their ultimate highs 4-5 years after gold peaked in 1980. This is part of "rear window market psychology", which hopefully does not require an explanation. Those participants were staring at the past thinking the road ahead of them was similar to the past...which was unlikely. From 1982 till 2000, the greatest bull market in history occurred, along with a decline in interest rates. The period of 2000 till present has had stock markets lifted higher because of a surge in liquidity from Central Banks, yet interest rates have been kept low. Everyone is still in the "bubble psychology mode" at present, which translates into expectations for high market performance. Once gold and silver stocks start to move, the public will fully embrace it as opposed to the initial doubts experienced from 1972-1980, but only towards the latter phase of the cycle.
There likely will be shortages of gold and silver for the next 20-40 years, simply because mining output will be restricted due to shortages in oil available for producing gas to drive motors. After the peak in gold and silver prices, they will fall back, but not to the lows of $250; I anticipate gold to hit around $6,000-10,000 Canadian dollars and then lose around 50-60% of the value, stabilizing around $4,000/ounce (Canadian Loonie to $3/USD, which is 0.33 cents USD/Canadian Loonie). Note: I do not put the price in USD, because the price of gold in USD will be a function of how much the USD FED decides to inflate their currency and that is a wildcard.
There are two different schools of thought regarding currencies, one being Austrian economics (Von Mises) and the other being Keynesian economics. Von Mises is from the Austrian School of Economics that focuses on the use of gold as a backed currency to regulate the expansion of money. This is probably the best article describing the way an economy should function: http://www.econlib.org/library/mises/msTContents.html. The counter theory to the Austrian school of economics is that proposed by John Maynard Keynes. Keynes was an economist from the 30's who came up with the current model for the expansion of fiat currency. The following thread describes Keynes aka Keynesian economics: http://en.wikipedia.org/wiki/John_Maynard_Keynes
Monetary expansion is the cause of inflation. Think of playing a game of monopoly by throwing in a few more bundles of money (inflation) or taking money away (deflation). The price of "things" rising is a result of excess money. The prices of certain items may increase or even decline in price, but this is often a function of the supply of something (increased productivity results into a decline in costs e.g. TV's). The price of commodities is subject to price increases based upon supply and demand. The overall trend of inflation will be seen with an expansion of the money supply either through direct introduction of physical money or through the introduction of credit.
Below is another thread defining inflation: http://www.inflationdata.com/Inflation/Inflation_Articles/Inflation_cause_and_effect.asp
Within the cycles of inflation, there is also the cycle of long-term interest rates. I wrote a piece on the web a number of years ago about inflation: http://www.safehaven.com/showarticle.cfm?id=3431. The US government used to keep track of accurate statistics regarding inflation, but altered the equation when Bill Clinton came to office. Lowering the actual rate of inflation lowers the government requirements for paying pensions etc. that are inflation adjusted and does not raise any alarm bells with the populace that inflation is a problem. The above article I wrote has a final figure showing inflation during the 80's. Although interest rates peaked around 22% in 1980 and declined till around 2000, inflation still ticked upward at 2-3% YOY due to expansion of the money supply. Interest rate cycles from top to bottom tend to last for 20-30 years. When interest rates are cranked high, it literally stops economies, thereby allowing another boom to occur once the cycle starts up again.
When countries print a lot of money, it lowers the value of their currency, which is exactly what is happening with the US dollar (USD). The US lowered interest rates to try and aid the homeowners and banks that have overextended credit, which is not providing any support for the USD. In the not too distant future, the US government is going to have to raise interest rates in order to stabilize their currency. At some point, gold-backed currencies are going to come back into fashion, which will restrict the ability of governments to be able to print money they do not have, but that is some time from now.
Banks function today by making use of a fractional reserve system, requiring them to only hold around 10% of any funds deposited there. e.g. If someone puts $10,000 into their bank account, then the bank is only required to keep $1000 and use the other $9000 for loans. This creates a fractal that just extends further and further until it can no longer support itself (this further exacerbates inflation).
Under Keynesian economics, raising interest rates is a lever that governments use to prevent economies from overheating due to the expansion of currencies. At the present point in the inflationary cycle, the US is set to have high interest rates in 3-4 years, if not sooner. In 5-6 years, the commodity bull market will finally terminate due to the inflation cycle ending with high interest rates.
During periods of inflation, such as we are in right now, phony government statistics use something called "core inflation" which excludes food and energy prices. Core inflation is running around 2-3% at present...factor in the price of food and energy and it is around 8-10%/annum. John Williams runs a site called www.shadowstatistics.com and keeps track of M3 (which was discontinued in March 2006 to hide the US government expansion of their currency), which is running just above 16% per annum at present.
Keeping money in bank accounts at present is bad, because being paid 4%, take away 50% due to taxes on interest and the next gain is 2% in an environment where inflation is running at 8-10%/year. Over the course of 10 years, cash will be losing purchasing power of 6-8% compounded year over year. Bonds do terrible in periods of inflation, even if a ladder approach is used e.g. if 10-year bonds are issued in 2006 at 4% and bonds in 2008 are issued at 8%, the face value of the 2006 bonds will decline. Even though the full face value of the 2006 bond will be paid in full, the loss of purchasing power due to inflation will kick in. Near the end of an inflationary cycle, it is best to role money into 3 month T-bills until a top has been determined. Subsequently, money is rotated into long-term bonds as a period of disinflation (1980-2000) or deflation occurs (1929-1932). Note: Gold is important as a store of value during periods of negative interest rates (as per now), rising interest rates and deflation. Gold does NOT do well during periods of disinflation.
The period of turmoil is going to likely see the 3 Bears of the US economy go sideways or even slightly higher in nominal terms...express them in other currencies and the bear market will be evident.
P.S. Remember to take two minutes out today (November 11th) to pay respect for those who went before us to grant us the freedoms we currently take for granted.
