Thin Air Standard

By: Ed Bugos | Thu, Dec 19, 2002
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We don't actually hope to go back to the old ways of using gold coinage; it's just that the Federal Reserve's monetary policies keep driving us there. Or put another way; capitalism and private property are to productivity what inflation policies are to gold demand.

Warning: if you find our point of view objectionable, disagree entirely, and conclude we're quacks, we're ecstatic. It means the bull market in gold is young, because, well, we were there. I know from my own life experiences, just when I had confidence that I understood something, I saw it in an entirely different light. In fact, I am nobody, as in nobody knew that gold bottomed in 1999!

The bull market in gold is, or was, one of the easiest calls we've ever made, but yet, the most frustrating to communicate to anyone outside of the choir. The writing has been on the proverbial wall ever since 1999 when the Bank of England announced it was going to auction off its remaining gold. The reasons to be bullish on gold were so obvious that only the most bearishly biased or inexperienced couldn't see them. This continues to be the case today.

I suppose "I told you so" is getting tired. How about, "Holy cow, you mean, we were right?" (for more details on our asset model see:

Ok, so we're not actually surprised, but I thought the bears would get a kick out of it. Gold has been in a steady but choppy ascent for two years now. The leg that began in 2000 is technically a primary leg, and the break through $340 turns the primary sequence bullish. We're defining the primary sequence by either one of two possible chart interpretations.

The prognosis of the latter sequence is less clear than the first. The technical objective of the current breakout of gold's 6-month congestion range is about $365, and it's conceivable that this (two year) primary leg ends there for a while, and turns down into a primary countertrend bear market leg. But it's not our most likely scenario, at least not if we're right about the dollar's immediate downside.

Bears are likely to argue that the bear market parameters are intact at $425, or the 1996 high. They are right that there will be resistance there. At least there should be. But I think they are going to be wrong that their bear market is intact. This is the first time in over 20 years that we've seen a bullish combination of higher lows and higher highs in the primary sequence. Whatever the immediate market prognosis is now, we are confident this is the bull market signal we've all been waiting for.

All of our other technical criteria have confirmed gold's primary bullish sequence. The CRB chart is almost an exact replica of gold's chart in the primary cycle. There too, last week's new five year highs could represent either the breakout from a five year double bottom or a primary sequence of higher lows and higher highs. To confirm a gold bull market and a dollar bear market we said that gold would need to get through $340, the dollar index would have to fall through July's low, and either the CRB, oil, or the Goldman Sachs commodity index would have to reverse their primary bear market legs. The CRB has satisfied our criteria.

Oil prices are flirting with primary bear market resistance at the moment ($31), but the Goldman Sachs index made a new high in its intermediate sequence, which technically reversed the bear leg that took the index down during 2001. The index is already positioned within a primary bullish sequence. We view it as confirmation of the CRB move, but would like to see oil over $31 to scream bull.

For its part, the US dollar index fell through July's low (104) on Tuesday to register a new 33-month low and also satisfy our criteria. The fact that the breakdown so far is marginal is of little concern to us, because our confidence is high that gold is a leading indicator of where the dollar's going.

Dear Richard (Russell),
with due respect, you're wrong; gold bugs are bullish, unfortunately I presume. I hate to ruin a perfectly good bullish slant, but gold bulls turned the Amex gold bugs index around last June when they took out the 1999 high. Only, they pulled back when gold refused to signal a bull market in kind.

The pullback was volatile, but the bulls were able to keep the unhedged Amex Gold Bugs Index, the only gold index to break through its 1999 highs in the first place, from falling back below that point in the subsequent correction. So even while gold failed to signal a bull market, the bulls maintained a primary bull market argument in gold shares. They got ahead of themselves, and are lagging gold today, but it's hard to argue they aren't still ahead of gold prices.

But maybe you're correct to bring attention to their recent underperformance nevertheless, as an indication that sentiment is not overly bullish yet. Thank you.

The Dollar Barometer
The reasons for gold's breakout can't be pinpointed to any one development. GATA believes the market is exploding because it has bought the bullion/central bank short story, Blanchard believes it's exploding because they're suing Morgan and Barrick, the beltway believes it's exploding because of US-Iraqi tensions, James Sinclair thinks its exploding because he's been promoting it (good work Jim, forgive the jest), astute market watchers think it's exploding because of a Wall Street bear market. We think it's exploding for all these reasons to one extent or another, but by far, the main reason gold prices are exploding is because they're forecasting a weak dollar, perhaps a collapsing US dollar. Keep your eye on the ball.

Inflation Is A Virus
Theoretically, strong productivity advances almost always result in increasing output per unit of labor. In the real world, while that is true, there are other factors that corrupt both, the calculation and the theory. The calculation is corrupted by inflation and the theory is corrupted by gold's opponents, or the groups that are most vested for sustaining the inflation in currency, money, and credit.

Let me briefly explain. In a given economy, if there were no change in money supply, any technological improvement should result in more output, and lower prices. Thus, the calculation output per unit of labor wouldn't capture the advance the way it does today. In theory, labor prices would come down as well, though in reality they are known to be sticky in that direction.

Of course, I would attribute it to the fact that inflationism is itself so deep-rooted in our society, and ancestry. We see it as a virus causing symptoms such as temporary blindness, ponzi-schemitis, deflation-phobia, gambling fever, random trading addictions, borrower's insomnia, egomanias, chronic optimism, looter-phrenia, larcenist obesity, bubble-denial, herding behaviors, and of course at times, total confusion. In extreme cases, confidence in government initiatives / plans can grow.

Anyway, when you have an inflationist monetary system like we do, this calculation essentially measures the effectiveness of the inflation policy in sustaining profits.

I know it is difficult to imagine an economic system where money and credit don't expand, and so, as a consequence, we've gradually adjusted our views of inflation to this moving train. Ok, the train analogy worked for Einstein; maybe it can work here to explain why most people can't see the inflation today… because maybe they've jumped on the train, if you will. Most everyone has a vested interest in the inflation of money and credit today. Maybe that's why investors think Japan has a deflation problem, because the train they're on has been moving so fast.

The point is that common interpretations of most of the economic data completely exclude the effects that monetary variables have on the data. The Fed says that we have no inflation because we have productivity, and it also implies that productivity is behind the strength in the dollar. Recall that theoretically, productivity gains translate into more goods, thus lower prices. This also means that the value of money rises. Today's economists might call that deflation, since they only see either inflation or deflation when it affects the aggregate price level, or the value of money.

Here's the conundrum. What is it when the central bank lowers interest rates, money supply expands, resulting in an inflation of equity valuations, and a consequent rise in foreign demand for the financial assets denominated in that currency? Does a rise in the value of a currency this way mean deflation? Hah. Look, the dollar has risen for five years for this precise reason, because it has attracted foreign currency; because nowhere on earth could investors (think to) get the kind of bang for their bucks as they could on Wall Street.

We aren't arguing productivity doesn't exist or that there isn't more of it in the United States than most anywhere else. What we've argued is that it's been overrun by the enormity of the free banking world's inflation doctrine. The Fed would argue that the dollar rose for the same reasons we would, foreign investment demand, but it would argue against our charge that inflation caused counterfeit stock market gains in the late nineties, or at any time for that matter. In fact, as you know, the Fed argues inflation doesn't exist at all (the Fed is the free banking world's spokesperson and lender of last resort).

If Wall Street's bull was a bubble, it was inflation induced, and to that extent, whatever valuations it sustained are in the process of being reversed now.

The Fed has been stepping on the gas pedal since the beginning of 2001 to fight off that corrective process, and for the first time in at least 70 years, confidence in the dollar remained strong long after Wall Street's bear market showed up. Both of these facts are unprecedented in their own way, but the dollar has finally begun to crumble this year under both, economic and political pressures.

To the extent that the dollar's gains in the nineties were the result of, or related to, the bullish but fleeting expansion in financial values, it's overvalued. That's a subjective assessment and it's going to stay that way until we change our mind, or until gold, stock, and commodity prices begin to tell another story.

Indeed, gold and commodity prices are rising because they're anticipating dollar devaluation. That is our main argument. And the reason our confidence in the dollar's demise is so strong is because we believe the tools the Fed used to prop up the dollar have been exhausted. Of course, productivity must be around, but it has little or no bearing on this argument at the moment. For, if Wall Street is suffering now from the backlash of a bubble environment today, caused by inflation and marked by overvaluation in the dollar, what is it going to suffer tomorrow as a result of the effects on the economy of the profuse inflation since the bear market began?

Let's put it this way. Banks like it when credit and currency supplies expand because their balance sheets expand in proportion. If such an expansion in monetary aggregates occurs alongside a stable or rising value of the currency the assets are denominated in, all the better. What lenders can't tolerate is when the value of this currency falls, which it tends to do when there's too much of it, or if it's too easy for too long.

The free banking world has a vested interest in the inflation, but it can't tolerate dollar devaluation. Inflation is "under control" when the dollar's value is manageable, but it is out of control when the dollar devalues.

The banking system is in trouble today, not just because it has a short position in gold, but also because it's losing control over this wealth transfer, if you will. In other words, because of the effects a falling dollar will have on prices, interest rates, and thus, the value of their assets.

It's no secret that by manipulating gold prices, one could theoretically control the inflation, or more accurately, sustain it, for as long as they could manipulate the gold price. The reason is that what they're really doing is manipulating the value of the currency. Combine that with a printing press and you own the world. By fixing the gold price, whether by clandestine manipulation or public declaration, the policy is actually aimed at fixing the value of the currency that is supposed to be money, but that can come to life out of thin air. Thus, instead of a gold standard maybe it should be called the "Thin Air Standard." Alas, our title.

The point is that gold's opponents are the same people that support the inflation aristocracy. There can be no question of motive. It's as plain as day. The only people that can't see it are those still on board the train, who find comfort in theories of elastic money, perverted extremes of utilitarian ideas, monetarism, government policies, and who remain unaware of the "relative" (Mises would say subjective) nature of valuation. To them, anything that is moving slower than the train is deflation; anything moving faster is inflation; and anything that's moving the same speed is simply not moving. It's absolute, not relative, and so, when they see that the gold sector is only a fraction of the size of the financial sector today, they ask, why on earth would anyone care about an industry so insignificant, in proportion to the market capitalization of say, Microsoft?

If this is your question, we aren't going to answer it, because we want you to sweat it out yourself. Go short gold. Believe in your conviction! You're right, the gold sector is insignificant relative to the "inflation" in other financial values, and even relative to other measures of industry, if you accept the Austrian theory of malinvestment as we do, since it has yet to be proven false.

So in Peter Lynch's style, two sentences or less, here's why gold is beginning a bull market: Wall Street's bull market was largely phony and the result of unsustainable easy money dogma; the same monetary factors lending to the overvaluation of the US dollar have been exhausted, and a decade-worth of imbalances in the gold market are about to be unleashed on a market saturated with dollar denominated financial assets or reserves.

We believe there has been manipulation, but we also believe that manipulation is fruitless, at least directly, and that it couldn't have been managed without the help of other factors related to dollar and investment policy (the part where they keep inflation under control). These other factors, it could be argued, were also market driven in part. In other words, if there were inflation, we would argue it inflated market developments that were already under way. Whatever the actuality, what we're trying to say is that, manipulation or not, gold prices may have still gone down during the nineties, but the reasons for the decline were unsustainable nonetheless.

The main thing we have to say about Blanchard's lawsuit against JP Morgan and Barrick at the moment is that they better have money. It's costly to pursue legal actions as controversial as this. It would be better just to act on the knowledge, in my view. At least it would be cheaper. But that doesn't mean we won't root for 'em anyhow.

We don't agree with the claim that gold would have been at $740 if prices were allowed to respond to the natural forces of supply and demand, as the lawsuit alleges. At least not to the extent that any coordinated manipulation could alone have that kind of impact. To the extent that policies were aimed at maximizing the value of the dollar, we would agree that the forces of demand and supply weren't natural; the effects of inflation on paper values distorted them, and we believe would have with or without any manipulation.

However, we do agree the manipulation existed nonetheless, and that it had some impact. Moreover, this impact is just as bullish now as it was bearish then. If gold prices were fixed lower than the market would have pinned them at, the fact would simply add to the imbalances that were already accruing to the same extent. In other words, the upside has been made larger by the gold market suppression by whatever extent you think it was manipulated. If we were simply greedy gold bulls, we'd send Greenspan et al a thank you letter for all of it. But there are enormous social consequences to the manipulation of money and credit.

Our view is that Blanchard and co has better standing than Reg Howe, in that Reg didn't do business with his plaintiffs directly, so they alleged he couldn't have been hurt, and thus had no real standing. Blanchard is a large coin dealer that's done business with both Barrick and Morgan I presume. It also has timing on its side. The rising price of gold is going to make it increasingly difficult for banks to hide any losses stemming from a short position in gold, and the growing spotlight on their accounting practices involving Enron type prepay agreements is making the idea increasingly plausible.

The difficulty is probably going to be the fact that Blanchard's success would set a precedent that the court would not tolerate - almost anyone could cash in. This is an objection that was raised in the Howe case as well.

Good luck to them. We believe they're charges are with merit.


Ed Bugos

Author: Ed Bugos

Edmond J. Bugos

Ed Bugos is a former stockbroker, founder of, one of the original contributing editors to and former editor of the Gold & Options Trader. He continues to publish commentary on market and economic trends; and provides gold, economic and mining research to private clients worldwide.

The editor is not a registered advisory and does not give investment advice. Our comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While we believe our statements to be true, they always depend on the reliability of our own credible sources. We recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

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