Saturday, May 28, 2011

When Will the Rapture Come? Trying to Predict Inflation and Gold Price Performance

Problem:  Everyone now knows the bull case for gold, silver, precious metals, and even uranium and rare earths.  However, for all the gold bugs predicting the demise of fiat currencies - both crusty curmudgeons and suited hedge fund managers - no one is offering insights as to when and how much gold will appreciate.  And thinking 3 moves ahead, no one is talking about how difficult it will be to time their exit from these investments.

Mainstream news media and stock discussion boards have now fully caught on to the investment thesis for precious metals.  Government money printing, via bailouts, QE, and bond buying will destroy the value of fiat currencies over time.  Ok, got it.  No need for another college dorm stock blogger to give me the 101 lecture. (If you'd still like to review these cliches, will be happy to oblige.)

But when is this going to materialize? Over what time frame?  Or can a fair argument be made that it already has materialized, with gold up 500% over the past decade?  After all, we've only tripled the US dollar supply, but gold has run up 5x.  Have we overshot?

I knew that the fiat currency inflation argument had come in to the mainstream-minority when a brilliant hedge funder who I've long debated the issue with joined me in the summer of 2010 in ridiculing the notion that the deflation trade would bear fruit.  Clearly 2010 was not the first time since the 2008 crash we heard about deflation.  But even within the deflationary talk, there are periods of increased or decreased fear.  The deflationary scare, already in full force among the central bankers and monetary elite, manifested in to a mini-scare among professional investors in 2010.

August 2009:
May 2010:

Coming from a Wall Street background, I can tell you that America's financial elite have long dismissed the gold thesis (and I was among them).  Wall Street, for all that you deride it as a den of foolish thieves, is genuinely home to some of the smartest people.  They, rightly, don't view gold as an "investment" per se.  Gold doesn't produce anything.  And so they default to their Keynesian brainwashing from their university days, telling them gold is simply a trinket for jesus-freaks, akin to the Coke bottle from The Gods Must Be Crazy.

[More on this in:  They Don't Do Anything:  Marx on Buffet, and Buffet on Gold in June on]

So a funny thing happened last summer.  The brilliant hedge funder with little fanfare told me the deflation trade was widespread in the Wall Street community and that many would end up regretting it.  He stopped short of agreeing inflation was coming.  But he had accepted the premise that money printing was not compatible with ongoing deflation.  That basic acceptance will lead to further acceptances over a longer time span, but it was a basic rejection of Keynesian fears that recession and inflation  must occur together.

[More on this in: Tearing Out Pages: The Soviet Encyclopedia Approach to University Economics Classes, coming in June on]

So what does the "mainstream-minority's" acceptance of the fundamental fiat currency thesis tell us about the timing and magnitude of inflation and gold prices?  A few things, albeit indirectly:

1. For those who, as Jim Dines would say, have a "hyper-need to be right", hedge fund & Wall Street validation of the gold thesis will provide the first-mover excuse they need.  They're the "influencers", if you're in to the whole Tipping Point thing.

2. The game is on to calculate a "value" for gold.  Wall Street loves quantitative valuations as much as a daytrader loves playing connect-the-dots and calling it "technical analysis".  As more Chinese middle-class and American E*Traders trickle in to gold, the challenge of quantifying fundamental values and exit points will begin in earnest.  Expect research from major investment banks calculating gold prices as a multiple of fiat currency money supply at some point.  (This may actually signal a top in the market, as these pseudo-scientific calculations will simply justify capitulation to rising gold prices when they finally come out.)

Ok, some hedge funds accept gold, and neurotically try to calculate value. Does that help us?  George Soros is selling.  Isn't he an influencer?

Yes, he is.  He was one of the big ones.  But he got in early and made his money.  The entry of new players, including retail investors, has made the game harder for him.  More volatility.  And likely being a Keynesian at heart, he's afraid the Tea Party movement to balance our checkbook will take the wind out of his golden sails.  But influencers do not agree all the time.  In fact, just as hipsters caught on to Greenday and polo shirts early, and jumped out before the crowd got on board, Soros made it cool but was uncomfortable doing something a lot of other people starting doing.

The reason the American mainstream is important is that they are finally lending credence to the idea that the real bubble is in the US dollar.  The US dollar bubble took decades to build.  It will not pop overnight, and it may feel slow when it happens, but when we look back it will be clear how quickly it all happened.  The hedge funds caught on early and the herd piled in.  But we're back to Fiat Currency 101.

How do we quantify all this, and understand when it will happen?

I have found a few worthwhile commentators.  I'll be clear right now:  None of this will provide Harold Camping-like accuracy as to the date the world will end.

1. Milton Friedman -- In Monetary Mischief, Friedman performs the only systematic analysis I have found reviewing not just the correlation but the timing of increases in the money supply with increases in inflation.  In fact, Chapter 8, The Cause and Cure of Inflation is worth the price of the entire book.

We hear that there is a "lag" between money creation, and the resulting inflation.  We understand from the numerous gold pundits that there is some correlation between money printing and inflation.  Friedman weighs in on both these issues:

On pages 194-195, after having discussed a litany of cases such as banana republics like Chile, Brazil, and the United States, he writes:
"These examples also show that the rate of monetary growth does not have a precise one-to-one correspondence to the rate of inflation.  However, I know no example in history of a substantial inflation lasting for more than a brief time that was not accompanied by a roughly corresponding rapid increase in the quantity of money; and no example of a rapid increase in the quantity of money that was not accompanied by a roughly corresponding substantial inflation."
Friedman is being a bit modest.  In earlier chapters, he's already highlighted that the very concept of inflation is subjective.  Its just not possible to capture a Platonic concept of "inflation" that fits the real world.  The price of everything goes up separately.  And not everything goes up in line.  Friedman demonstrates that inflation inherently favors certain groups (leveraged farmers in the late 1800's; leveraged real estate owners in the 1990's and 2000's).  So I argue that he should have been more detailed, as well as more circumspect, in his statement that there was not a "one-to-one" match.

We could nitpick here and point out that during the Black Plague, inflation was rampant even without an increase in the absolute money supply.  The problem was, with everyone going and dying, the same amount of money was chasing fewer goods & services.  The result was inflation, without a sustained increase in money supply (but perhaps an increase in the per capita money supply).

Later in the same chapter, on page 230, Friedman graphs a case study of Japan from 1960 to 1990.  Having not found a version of this graph online, and not wanting to insert a manual snapshot of the page, we'll put it this way:  Friedman graphs % increases in the money supply against % increases in prices (ie, inflation) with a 2 year lag.  So the graph for one is right on top of the other, time-shifted two years out.  The inflation percentages are lower than the the money supply increases, but the two graphs track each other - not always exactly, but often exactly.  For the period in the mid-1970s, inflation capped out at 20% exactly two years after monetary growth capped out at 25%.

Friedman writes:
"...with a two year lag, inflation tended to mimic even the minor wiggles in monetary growth after the policy change."
Does this analysis apply today?
Friedman's book was written in 1992, and I do not attempt to track all of his writings since then.  However, there are factors that seem to have increased the complexity of monetary flows over the past 20 years, which are not specifically addressed in his analyses:
  • Asset bubbles and complexities in calculating Platonic "inflation".  (Housing and gas already tripled, before food prices even budged.)
  • Complex definitions and measures of money supply
  • Government damping adjustment cycles.  For example, supporting real estate and bond values, preventing capital from flowing in to other asset classes, thereby evening out inflation.
  • Global factors, such as dollar hoarding by China and Japan, as well as safe-haven seekers everywhere, that have changed the patterns of dollar flows through the economy.  
  • U.S. corporate and bank cash hoarding may also be impacting dollar flows.
  • All of the above factors applied to the Euro and Pound.
  • The globalization of currency flows coupled with the psychological value of the dollar resulting in inflation being reflected in other currencies.
China functions in the global currency market like anyone cornering a market - controlling a significant portion of total supply, and a huge % of daily trading volume.  Right now, our government can conveniently transfer newly printed dollars in to bank accounts in China (and Japan).  And China, not wanting to tank the value of its own dollars, will dribble out the dollars over time in to other assets.  To the extent this thesis on Asian dollar hoarding is legitimate, Friedman does not address it as a factor in his book.

2. Jim Dines -- Jim Dines has long argued that gold will go to $3,000, and for a short time, spike to $5,000 on frenzied buying.  And to be fair, despite his track record of horrible investment recommendations rife with conflicts of interest (Clearly Canadian, CCBEF, and Mega Uranium, MGA), he has called a few things right - and even noted that it will be necessary at some point to sell gold.  He's called the bond market a bubble for years - years before Pimco caught on to this idea (and later dropped it). 

I see at least two valuable insights from Dines.

First, the image entitled "Mass Mind" (of flock of birds in flight), with a photo by Gianfranco Basili, in the inside cover of Mass Psychology (1996).  The herd mentality is nothing new.  But as I watch flocks of crows and seagulls from my balcony, it always reminds me that I cannot predict when the flock will change course - but when it changes, the entire flock will quickly reverse course.  Quite the opposite of trying to help you predict the timing of inflation:  This reminds me of the importance of having stamina to hold well thought-out investments for a long period of time, so that you end up still holding them when the flock does change course.

Second, Dines offers the antidote for the metals buyers who confidently claim "I never sell gold (or silver)".  Dines fully acknowledges that the point will come when we should sell, because the market will be spiking in a final, glorious burst of panic buying.  A true mania.

The hard part is to know when.  There are always pundits claiming the last gasp on the gold trade is here.  Soros' recent exit has refreshed such claims.  However, at some point there will be a last gasp.  It would be great to predict when that will be, or realize it as it happens.  With a hat tip to Nassim Nicholas Taleb, I will be modest and say I have absolutely no idea.  I might know it when I see it.

If that feels like a letdown conclusion, perhaps it is.  However, what it implies for me is this:  I will not try to sell at the top of the market, and I will not look back when I do sell.  I will rely on some level of fundamental insight to support my ongoing gold and commodities holding, but I will recognize when the market overheats.  I had this sense in the silver market in April, 2011. I got out, perhaps "too early".  As I write, silver is trading below where I sold SLV, so perhaps it wasn't too early.

I remain in gold right now precisely because most of the world has not yet reckoned with the fundamental catastrophe that will result from easy money and the Keynesian debt trap.  When the world, led by the influencers in the hedge fund world, begins piling out of the dollar and in to metals or oil or whatever else, it will be time to start the exit from gold.

I would like to hear the readers of weigh in with their own views on what will signal the final spike in gold.  Will it be 5 years from now or 15?

For now, it continues to rain dollars, and the rivers are starting to rise...

1 comment:

  1. It will very hard to tell. It takes a lot factor to consider. You just have to be vigilant on the changes of the economy.

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