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September 27, 2004

Gold - And the Parabolic Plateau
by Alex Wallenwein

What on earth is a "parabolic plateau"? Isn't that a contradiction in terms?

In the investment world, when an asset price trend experiences a parabolic curve, it exhibits a geometrically increasing slope that goes so high so fast that it eventually collapses in on itself and literally "crashes." Like the moods of a manic-depressive person, a parabolic rise-and-crash is synonymous with "excitement." A plateau, on the other hand, is the exact opposite. In investor lingo, it is the epitome of "flatness." In other words - boring.

How can these two go hand in hand, or even coexist in the same time frame? That's the subject of this part of September's issue of the Monitor.

The following thoughts are an extension of Adam Hamilton's recently published seminal gold editorial entitled Gold Bull's Three Stages. Please read that essay first, if you haven't already. Most of these thoughts are built directly on it.

Hamilton analyzes the current outlook for gold according to rock-bottom fundamentals and extrapolates from there to come to a conclusion that leaves such adjectives as "reasonable" or "highly probable" far behind. In my eyes, his essay portends near absolute inevitability.

But the purpose of this Monitor issue is not to prove that inevitability all over again by more facts and arguments. Instead, I want to invite you to join me on a short journey of what some might call a pure flight of fancy - and they may be right. In one sense it surely is speculation. Yet, in another more fundamental sense, what we are about to engage in is the application of experience, logic, and known economic processes to a set of circumstances dictated by nothing short of reality itself.

Just for orientation's sake, and not to belabor the points Hamilton makes, here are his main contentions:

1. Secular gold market trends are those that last three years or longer.

2. Secular trends can be slowed or exacerbated by manipulators (i.e., central banks, et al) both on the upside and downside - but they cannot be effectively opposed.

3. Unlike other economic goods, investment assets do not experience slowing demand with rising prices (as other commodities do), but demand actually accelerates as prices rise, persuading other investors to "get in" on the bandwagon.

4. In "Stage I", secular gold bulls attract only the contrarians, and are characterized by prices rising primarily in the currency in which gold is denominated (today, the dollar). The curve slowly rises.

5. In "Stage 2", other investors begin to take note and want in on the game, causing gold prices to rise in all currencies. The curve steepens.

6. In "Stage 3", the mania stage, investors throw all caution to the wind as gold's skyrocketing prices make headline news 24/7, driving prices ever higher way past the "equilibrium stage." The curve goes nearly vertical for a short period of time.

7. All manias eventually come crashing down, and so will gold's.

Hamilton's analysis is cogent and convincing, but when it comes to his final statement that the mania will come crashing back down is only true if you assume there is a currency system left to go back to once gold reaches the heights he forecasts.

The analysis totally changes if you assume that, by the time gold reaches such heights, the fiat systems that were so carefully crafted over the past few decades will have outlived their arguable usefulness - and will have succumbed to their genetic flaw: a condition that can only be called "worthlessitis."

Is this possible? Yes. Is it likely, then? Or is it just a naive phantasy? Let's take a look:

Hamilton predicts a time that should arrive within the next year or so in which other countries' investors are beginning to jump aboard the steam-gathering gold train. At that time gold will bust out of its dollar-shackles. It will no longer be a slave to the dollar's forex exchange movements but will rise even faster than the dollar is falling.

The problems for the dollar do not end here. If Hamilton's secular gold-bull scenario plays itself out to its conclusion, gold will go parabolic. That's already bad enough for the dollar, whose forex value will enter an inverse parabolic curve - downward.

What's really scary is that under this analysis, even though in "Stage II" the rise of gold will accelerate faster than the dollar's fall, this does not mean the dollar can from then on simply coast and ride out the storm.

At first, the gold price will rise faster than the dollar falls because it won't be only American investor's in whose currency the price of gold will be attractive. This means the dollar will no longer bear the brunt of the new gold rush all by itself. The effects will be spread over all of the major currencies.

But as this phenomenon spreads, central banks will be forced to recognize the inherent weakness in their currency systems. Witnessing the dollar's downfall they will, at first very slowly and reluctantly, and then with increasing ferocity, attempt to stock up on gold again to bolster confidence in their falling currencies in the eyes of their respective countries' citizens and foreign investors in their currencies. This is not to say they will return to a gold standard, but in an environment where even regular people within their own currency systems are loading up on gold, being able to point to increasing gold reserves will undoubtedly have the desired, nerve-calming effect on their subjects.**

Globally rising gold prices means globally falling fiat values - at least relative to gold. As against each other, in the forex markets, this "price effect" will not be terribly noticeable - except when it comes to the dollar. So, there are two possible scenarios:

1. The worldwide fiat currency system stays afloat as it only sinks as a whole relative to the price of gold. People who are conditioned to look at fiat as the measure of value only see an "investment opportunity" in gold. The notion that the entire fiat system may be in structural default does not enter their minds. So they merely "invest" in gold for future paper-profits, and the system survives; or ...

2. The nearly inconceivable run-up in gold prices presages a huge run-up in real asset prices that brings the entire fiat system to its long overdue demise. In this scenario, although foreign currencies more or less simultaneously sink relative to gold, they also drop relative to all other goods and services within their own spheres of use. Hyperinflation results, and people start to demand gold and silver in payment for goods. The difference this time: the hyperinflation is not limited to one country's currency (as in the oft-cited post WWI Germany example) but spreads among all systems simultaneously, spawning a wholesale exodus from fiat into precious metals.

Hyperinflation of the kind experienced by post-WWI Germany only threatens the very fabric of the economic system when prices far outpace rises in incomes. If the process is slower and increases in income are able to more or less keep up with the general price rises, then we have a scenario similar to what happened in the US since 1975. (See, http://www.a1-guide-to-gold-investments.com/euro-vs-dollar.html where the US CPI chart since 1975 reveals "only" a 300% increase in thirty years accompanied by largely commensurate income improvements.)

Unfortunately, there is a little hick-up in that calculation. Income increases can only keep the pace with price rises if what increases is people's actually disposable income, as that is the only kind of income that really counts.

Currently, the debt explosion that made the 2003-2004 economic and stock market "recovery" possible is set to choke off any possibility of disposable income climbing in a lockstep fashion with general price inflation. All of that illusory wealth supposedly created since early 2003 is totally dependent on low interest rates. Without these emergency-level interest rates, servicing this additional boatload of debt is no longer possible for ordinary consumers.

A case in point: Friday saw a huge rise in 2-year treasuries yields in response to lower than expected durable goods orders for August and report on leading economic indicators (third monthly decline in a row for the first time since early 2003) that throws serious doubts on Greenspan's attempts to call the recent economic flat-lining a "temporary soft-patch." Short to mid-term rates are the ones that affect consumers monthly credit card statements the most - and consumers are maxed-out.

We have now entered an era of continuous rate increases that has no chance of turning back anytime soon. Greenspan must raise, or the dollar will fail. A growing economy is the best excuse for raising rates without scaring people out of their wits, so a growing economy is exactly what we live in right now - at least according to the Fed's spin machine.

They are really not to be envied, those folks at the Fed. They must soft-pedal any news on inflation to keep consumers from pulling in their horns, while making sure that everyone believes that inflation is sufficiently large to warrant a new cycle of rate increases.

Currency traders will interpret any failure to raise rates in the next year or so as a sign of weakness for the dollar, which will hasten the dollar's inevitable decent into Hades. At the same time an actual rate decrease in this climate will be the equivalent of exchange-rate suicide for the dollar. So, rates must go up fast enough to keep the dollar from imploding, while they cannot go up too fast - or risk a pullback in consumer spending, which will bring the entire house of cards down in a flash.

Since rates will have to rise from now on - however slowly - disposable income will shrink.as a result of increasing debt repayments. Ergo: any price inflation caused by across-the-board drops in currency values relative to gold in the coming gold super-bull is bound to outpace disposable income inflation. Hyperinflation will most surely follow.

But things are not that simple. It gets even more complicated. This kind of inflation will be accompanied by a simultaneous deflation in other parts of the economy, especially those areas where it hurts the average consumer the most:

In housing prices!

The real asset price-bubble that was powered by the public and private spending spree we saw during the late nineties and early 2000s is simply not sustainable. Rising debt service costs shrink disposable incomes and therefore the ability to keep up with mortgage payments. A mere slowing in the fast-paced rise of the residential real estate market will bring price declines with it as the longer waiting times to sell a house forces owners to become more flexible with their asking prices. When the market actually goes into decline, even those new home owners who were smart enough to have locked in their rates will suffer as their total wealth position declines.

But it doesn't stop there, either. Another bubble that especially gold investors are familiar with has developed during the same time frame, and it has taken a herculean effort on the part of both Fed and government to keep this one from blowing since 1999. Stock valuations!

The same analysis applies to equities prices - with one additional twist: Homes aren't put on the market as quickly as stocks are sold when the fear sets in. Homes have a very high utility value to their owners. They need to live in them, and so they will do anything they can to hold on to them.

But stocks are very different.

Selling a stock takes but a mouse click in this age of online discount brokerages and electronic day trading. On top of that, stocks are often bought on margin, especially by profit-hungry short-term traders. That will speed the decline.

Given the parabolic nature of the stock market in the run-up to January 2000, the ensuing drop and subsequent rebound to a lower high from, which the market has since fallen again and to which it has tried vainly to ascend once more, we are now locked into a double-trouble sandwich-type situation.

On the one hand, we have rising interest rates with their negative effects in a still very fragile economy. On the other hand, we have home and equities prices that are set to fall precipitously. Stuck right in the middle of that is the US consumer - like a piece of baloney wedged between two looming catastrophes. As condiments, add an overwhelming debt load (for mayo) and a falling dollar with rising oil prices (for mustard), and you have the recipe for a nuclear-powered submarine sandwich.

If that consumer-baloney was made of carbon atoms, the coming high-pressure environment might turn it into diamonds someday but, alas, nobody has ever heard of baloney-diamonds! Have you?

The important thing to understand is that this deflationary trend, unfortunately, will not act to counterbalance the inflationary trends existing elsewhere in the economy. Maybe on some arcane and utterly cooked government books it will. Maybe the mainstream press will still inundate us with so-called news of oh-so-benign inflation figures - but as far as real people living in a real economy are concerned, the effects will be devastating.

Any actual human being will experience both a loss of purchasing power of his already curtailed income and a loss of asset values of those things (like real estate, stocks, and other paper investments) on which he or she has hoped to build a retirement fortune. The resulting picture is anything but pretty - and the powers that be have already shot their ammo before the final onslaught has even started. Don't think for a second that "Sir Alan" or "the government" will bail you out unless you are willing to trade even the last vestiges of your freedom in for a completely and centrally controlled market of the old Soviet kind - complete with "chip-in-your-hand" tracking of all economic decisions you make.

The fallout from the impact of these simultaneous financial economic asteroids on our investment planet will bring about an economic ice age in which nobody will be really "comfortable." In such an environment, the difference between owning only paper assets and owning primarily gold is not the difference between living on the edge and living in style. In that environment, the difference will lie between going over the edge - and living, period!

If this cataclysmic event should come to pass, the concept of the price of gold "peaking" and then returning to an "equilibrium" of sorts essentially becomes a non-issue, because the medium (fiat) in which gold s priced itself will have become a non-entity for all practical purposes.

When the commodity you are trying to "price" becomes the money in which everything else is priced, who cares whether the price of gold in terms of fiat currencies is "high" or "not high"? Then, the only thing that matters is how much of any other product or service a known quantity of gold will buy

If and when that situation arises, looked at from a fiat-economy perspective, gold bullion will never again "come down" in value, because fiat will never again recover from its inherent fatal disease. Universal fiat use will be a thing of the past.

Fiat is genetically defective, and that defect - once exposed so that even spoiled western fiat-junkie consumers can see it every day at the supermarket checkout - will never be cured. And we are currently on a path of no return that will lead to the defect's ultimate exposure. Not only that, but we have traveled that path almost to its destination, now. The time is not far.

Got gold?

** Will the "powers" respond by just pulling a new currency system out of their sleeve that can absorb all of this flight from the dollar and from fiat in general? Unlikely. Remember how long it took to get the euro off the ground? There is not even an indication that anything similar is in the works right now. The euro IS this "alternative system". Whether it can absorb the flight from the dollar, or whether that flight will turn into a headlong rush from all fiat currencies, remains to be seen.

Alex Wallenwein
Editor, Publisher
The Euro vs Dollar Monitor

Just like driving your car, investing only makes sense if you can see where you are going. The Euro vs Dollar Monitor is your golden windshield wiper that removes the media's greasy film of financial misinformation from your investment outlook. Don't drive your investment vehicle without it!

Copyright © 2003-2008 Alex Wallenwein

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