Dollar/Yen = Dollar/Gold
The key to a sudden resurgence in investment demand for gold is the "perception" that the dollar cannot hold its purchasing power, or its objective valuation. We will call this the point of recognition for the dollar.
There, that is about as good a gold call as anyone will get anywhere, especially since it isn't clouded with arbitrary price and time targets, but rather a timeless, relatively observable, condition.
It is funny about markets and human nature. It never fails; that what goes up must come down (though not necessarily vice versa). Yet, if this market fact is readily acknowledged, why is it that at market tops so many of us still get caught believing that this one is somehow different, in that it will not stop but continue to go up, and up? To be sure, there probably are as many reasons as examples, but maybe I can contribute a unique perspective.
Perhaps, at this hypothetical top, having just bought millions, or billions, of dollars worth of stock, you think to yourself "wouldn't it be silly now if we all had to turn around and sell what was just bought?" Of course, you may or may not have this enlightening thought before the market actually turns down, but regardless, the realization is that the shares should not have been bought in the first place… like maybe the day before.
In my own experience, no one can fool me as ingeniously as I can fool myself.
Right, maybe on some level we persuade ourselves that it is better to be wrong if everybody else is wrong than it is to be wrong all alone. In fact, it is during times of extreme one-way market sentiment that mass emotional imbalances like this tinker with the competitive forces, which foster a diversity of opinion and thus liquidity. In any case, it is at that moment when (if) that thought passes, where the men are separated from the boys. It is at that moment when you need to ask yourself, "did I really buy this crud for the long term?" How honest you are with yourself just then will determine how much money you will ultimately lose.
But if you lie to yourself, and it is a top, then odds are you're in it for the long run, dogmatically persuading yourself and others that in the end, these particular shares will somehow be worth more. Chances are that if you had persuaded yourself, on the way up, that investors don't (or shouldn't) sell stocks ever then you are already at a disadvantage… in making the necessary psychological adjustment. The buy and hold song is a confidence game. It doesn't work for trading speculative markets, which today (as well as yesterday) has become everything and anything denominated in paper.
It is absurd to believe that once people buy stock, they don't ever sell. Even, and maybe especially, if stocks just go up and up and up and up.
For, consider that one day they have been going up for so long that it doesn't even matter anymore. Planning for retirement gradually takes a back seat as the prospect for untold paper wealth lies just around the corner.
Of course, not everybody will be able to relate (or admit) to this particular set of experiences, but I hope you will. It comes from someone who has had the benefit of managing money for enough people that he is able to perhaps observe a common thread in human behavior.
Anyhow, as the need to plan for the long term becomes increasingly insignificant, people will generally raise their living standards in the present, perhaps even living beyond their current needs. Someone once told me that the thing about greed is that it is reliable. I will second that, and raise… it is as reliable as change itself. The point is that people will sell stocks, even if they do nothing but go up. Unfortunately, the transactions may not occur logically. In other words, it is more than conceivable that the rise in living standards comes not at the expense of the investor's equity stake, for that would apparently not be prudent. It might "apparently" be wiser to borrow the money instead. This way people will figure out a way to keep an "income"-producing stake in the stock market, for that is their wine and cheddar.
Speaking of that, let's check in on the condition of our paperweight, I mean, future.
So, was that a bubble, Mr. Greenspan?
Can we say that, now that we have the benefit of hindsight? We have been waiting for the opportunity to get that off our chests. I suppose that a quick glance at the two-year Nasdaq chart closes that argument off, for good.
Now, consider further, the possibility that the blue chip averages are choking off the potential for a rally in the Nasdaq, even from these levels, by virtue of the axe that has yet to fall. All that this means is that speculation needs leadership that ignites the imagination. Today that means something that is so bullish it makes a Dow drop to 7000 seem inconsequential and a breakout to new highs all but certain. But it also means, today, that it has to be something with substance, because there is no substance in the stock market's current valuation.
That being said, the bulls have been putting in one heck of an effort to will the market up. The breadth of US stock markets has been expanding rather consistently (and surprisingly) during this last month or so, prompting analysts to come out of the wood work in order to establish themselves as potential lead bulls. The word recession has been thrown around so much that they are beginning to use it to their favor in pointing out how stocks are not generally falling on bad news anymore.
That prompted us to look at the technical condition of the market extra close this week because certainly, these are valid points for the bullish case. As far as the discussion of recession is concerned, what doesn't wash with us is that if everyone has considered a recession to be a real risk, why are the stock markets only discounting a soft landing? And why do most sentiment indicators continue to gravitate toward optimistic readings? Maybe because the talk is still talk and no one has considered it a serious risk… maybe because Mr. Greenspan has promised to save the stock market for them.
Oh boy, did I just say promise? Yup! Though the promise is as shrouded with ambiguity as is the Fed's role in guaranteeing the debts of various mortgage issuers, it is nonetheless a promise, defined by his actions in office. Actions, which have become so notorious that history has already chosen a name for them: The Greenspan Put, his promise to America.
Hoover blew the whistle, Mellon rang the bell, Wall Street gave the signal, and the country went to hell. - depression era song invented by unknown author.
Hoover too, made promises he could not keep. Only broken promises can turn a man from someone having a national monument built in his name to someone whose name is only cursed, in a span of about three years.
Perhaps this time will be different however, as Mr. Bush confronts similar historical circumstances with a reality check for our delusional nation. Only time can tell. Back to the market…
So, what if Fed policy has become impotent?
The breadth observation is legitimate as far as it is a fact (see the above charts). However, an analysis of an observation entails much more than just plugging that "fact" into a convenient spot to provide support for an otherwise imperfect bullish argument. In this instance, the fact that the indexes are masking the bullish performance in the broad market is incomplete. It needs to be related to the past. For example, the broad market rolled over into a primary bear some time in 1999, but that fact had been masked for a considerable period of time afterwards, by the bullish performance of the relative "minority" of stocks, which had an enormous statistical impact on the averages. Additionally, these are facts that the blue chip indexes have yet to expose, or confirm. Thus, to the extent that the big blue chip averages continue to obscure "this" fact, the invisible broad market rally is probably just your average bear market rally.
Furthermore, it is our contention that the market cannot meaningfully bottom while analysts are still swift in their dedication to the bullish cause. That psychology has to be purged if this is going to be a bona fide stock market bottom.
The NYSE composite put in a little bounce last week, which could easily be nothing more than a typical retracement in an overall bearish circumstance, or at best, neutral technical circumstance. The Dow Industrials didn't. Bounce that is. In fact, the average spent all week long trading sluggishly beneath its fast (50 day) moving average, ending the week at the low end of the week's trading range. To us, that is a bearish development for a few reasons. The most important is technical, and has to do with the fact that the week before, the average closed the week flat on its bum after a rate cut. Where were the wise analysts then, to tell you that the market is not going up on good news? Probably in the same penalty box that Abby Cohen is in for calling 10% rises, but never calling for 10% declines…
How much better do the bulls want then a 50 basis point surprise inter-meeting Fed move like that, on both the funds rate and the discount rate? Nonetheless, the speculative Nasdaq Composite tried real hard to break away and establish a one-month diamond on the chart, perhaps trying to follow the AMEX composite. It ran out of time, however, and right into a steep downward sloping trend line, by Friday's session last week, which is still firmly controlled by the bear (since September).
It remains to be seen whether the bulls can overcome. A turnaround will require that bulls take out the first point of resistance at roughly 2800 (50 day moving average) before charging away at the bearish stronghold, slightly above 3000. It is not an even fight, it is a bear market... thus, any failure to turn things around this week ought to resolve in bearish reassertion, shortly thereafter.
The only two things that the bulls have on their side, and which come to mind, are the laws of physics ensuring an inevitable bounce, and an old trader's myth, which states that a short week runs countertrend. Oh, and they also have the Fed on their side, though we do not view that as an asset any longer. For if the eroding value of the currency, the dollar in this case, begins to erode along with it, the benign state of disinflation, which investors in higher risk tech issues are used to and require, where is the rationale for speculative stock valuations?
The key to the Nasdaq is going to be the S&P500, which technicals better match the Nasdaq and the AMEX than they do the blue chip markets. Indeed, here you will find the same structural (bearish) controls on prices as you do in the speculative averages. The reasons, which we know, are less important than the observation. For the observation implies that the destinies of both averages are intertwined, at least in some ways, and further, that a Nasdaq rally probably cannot sustain without confirmation from the S&P, its CEO. On the other hand, the blue chip averages, NYSE comp and DJIA, are going to be hard pressed to make new highs stick, without a similar confirmation from the broader (distribution of the) SP500.
So regardless of how perky the illiquid speculative issues appear, certainly the broad market still looks heavy. Thus, we maintain that a leadership rally out of the Nasdaq, without confirmation from the S&P500 and/or the other blue chip averages, will precede a crash in the blue chip markets. Further, if the bulls are a no show tomorrow, we fully expect the put/call ratio, which has given us another sell signal as of Thursday afternoon, to rack up some gains, quickly.
Perhaps the bond will guarantee it....
In the case of the bond, it did break out of a diamond… down. Both, prices and yields resolved a one-month diamond pattern (typically a short term reversal pattern on the chart). Another obstacle for the Nasdaq, and maybe another lead for the financials and the bank stocks this week. The S&P Insurance index has already slipped, undoubtedly related to the "stuff" that they may have been buying in the money markets lately, as so many other companies have been finding out about their balance sheets also. This time, the bad news bears are the California Utility companies.
The transportation and airlines issues pulled back last week, though they are only now coming off of a two-month winning streak. The average bears watching closely over the ensuing week or two, as participants have been expecting the December correction in oil prices to prop up fourth quarter earnings. We don't think that the rally has got legs, especially if we are correct on higher energy prices ahead. The relevance here is in the psychological blow to the bullish camp when (if) this average reverses the otherwise beautiful double bottom on the two-year chart.
The utilities are now wrangled in a political nightmare, which cannot be bullish in the near term, at least psychologically. Accordingly, the Dow Utility Average slipped last week, though in this case, the slip comes after the Average pierced the 40 week moving average only the week before. The development bears watching because government intervention in the industry cannot be good for its component utility companies.
Well, so much for stocks, they appear to be passé anyhow. What of gold? Can gold go down, and never come back? That depends on how you look at it, I suppose. Unfortunately, the way we look at it is that it is the dollar, which has sucked everybody in.
It is the dollar, which has been created out of thin air, as every other paper currency ever has. Gold has been around a bit longer. Wars have been fought over it. Would anyone invade America to steal dollars? Not likely, for they would be rendered useless then wouldn't they? We would likely have to use the invader's currency.
However, in (North) America, we have concluded that once a dollar is bought, it is bought. There is no reason for buyers to turn into sellers, especially if the currency goes up and up and up and up. Sound familiar? Right, just like stocks. There is no difference. Well, there is one big difference. Stocks can only be priced in paper. Their value is relative only to the currency.
But in todays overly, and perhaps deliberately, complex currency arrangement, a currency is valued relative to other currencies as well as relative to the things with which it can buy. This latter is called a currency's objective value. For all intents and purposes, the former is the currency's subjective value. This subjective value can be maintained so long as all is well in the world and other governments co-operate.
But what determines their cooperation? A formula that works for them equally as well as it does for us. For most of this decade, this cooperation existed because the dollar, still deemed the international reserve currency, performed. No, not just in its price relative to other currencies, but also in its ability to contain the prices of real things, which in the end, a currency is intended to buy… thus, the concept of objective value.
But this period of "performance" came at a price. The strong dollar policy knocked other developing economies, which were playing around with free-floating exchange rate regimes, right out of the water. In doing so, it accelerated the manipulative monetary forces, which were already at play in America, and turned the dollar into a global magnet for capital. While this trend created all sorts of imbalances in markets such as oil and palladium, not to mention our terms of trade, self-perception, and credit, we began to find all sorts of reasons for this inflating "subjective" value. Many of them we are now beginning to suspect as at least not quite right, but still, too many of us are at the early phase of that revelation, still expecting the Nasdaq to lead the party, etc.
Now, this "reasoning" is all still occurring even while the objective value of the dollar has already been falling for nearly two years. Since we have been trained (through decades of dollar reign) to price commodities in terms of dollars, rather than dollars in terms of commodities, our understanding of the concept of inflation has never been more erroneous, ever.
Let's keep it simple shall we? Inflation is simply any expansion of the money supply. Thus, we are Inflationists because our economy depends on the manipulation of the money supply. When this inflation no longer works, it breaks down, and causes a reversion of the currency to its "objective" value, whatever that may be. This has been happening for over a year now, but few participants recognize it and fewer still understand its significance. Why is that? Again, it is because most of us know nothing of this ancient logic. But as the guardian of our currency churns out ever more of it, this problem is likely to become much more visible.
Inflationism is that monetary policy that seeks to increase the quantity of money. Native inflationism demands an increase in the quantity of money without suspecting that this will diminish the purchasing power of the money. It wants more money because in its eyes the mere abundance of money is wealth. Fiat money! Let the state "create" money, and make the poor rich, and free them from the bonds of the capitalists! How foolish to forgo the opportunity of making everybody rich, and consequently happy, that the state's right to create money gives it! How wrong to forgo it simply because this would run counter to the interests of the rich! How wicked of the economists to assert that it is not within the power of the state to create wealth by means of the printing press! Other Inflationists realize very well that an increase in the quantity of money reduces the purchasing power of the monetary unit. But they endeavor to secure inflation nonetheless, because of its effect on the value of money; they want depreciation because they want to favor debtors at the expense of creditors and because they want to encourage exportation and make importation difficult. Others, again, recommend depreciation for the sake of its supposed property of stimulating production and encouraging the spirit of enterprise. -Ludwig von Mises, The Theory of Money and Credit
Furthermore, there is significance to the presently declining purchasing power of the dollar, a very big significance. The foreigners who had bought dollars over the decade, or longer, are not likely to cooperate with the US government if it does not guard their investment in dollars, the international reserve currency, from inflation, this "real" inflation, which when breaking down, always destroys the purchasing power of a currency. Are the Europeans, for example, going to want the Euro to go down with the dollar? Who is going to cooperate with the currency policy of a nation who reacts to the monetary crisis by issuing more money, does not recognize the inflation exacerbating aspect of state intervention in the California oil crisis, and who keeps piling on the debt in both, the public and private sector?
Interlude: The Power Crisis
No, we don't mean the Oval Office.
History ought to record the root cause of the California power crisis as; the Federal Reserve System in the United States financed a stock and real estate bubble so large that it literally blew a circuit breaker in the heart of bubble America -- California.
According to press reports, the State of California is about to be endowed with the responsibility of buying wholesale electricity in bulk, secured by long-term contracts with sellers that agree to sell the state of California their electricity today at an acceptable (fixed?) long-term price, on behalf of the state's less capitalized utility companies, and in order to smooth the disruptive forces of the market by selling it at a discount to the same utility companies. Better known as subsidization, the question thus becomes, how is this intervention going to interact with the market price mechanism?
First of all, aren't we taught that intervention cannot affect a change in market trends? Why then would the state's intervention in California's energy crisis be any different? Ok, the intention is to smooth rather than change, right? How can an economic system, which encourages demand even when that may be part of the problem, do anything but accentuate the trend? Of course, we are certain that Clinton and Summers believe that this move will help transfer some of the visible inflation to the less visible electricity market. Thus, we think that our focus ought to stay on the interaction between state and free markets.
I am reminded of a quote, as I ponder our government's reactions to the inflation breakdown of the seventies:
A man who does not learn from his mistakes is a fool, but a man who does, while he is guaranteed not to make the same mistake again, he is also guaranteed to make one of a thousand of its cousins.
Back to the dollar…
Of course, the Europeans have to play along for now. They have to give the Fed and the incoming administration some room to maneuver, undeniably, because they have a vested interest in the same paper currency regime, perhaps for lack of a better one. To be sure, everyone does. But again, that would be missing the point, which is that the inflation is not working, and not likely to work, for the Fed any longer. A new world currency is required in order to keep people believing in the inflation. Think about that one for a while, and then consider the following:
The Japanese aren't waiting around to find out whether there is or isn't going to be a dollar problem. They have been talking up the French to join them in their effort to develop an Asian currency bloc. And word is, the French are listening.
Over the weekend, according to the South China Morning Post, "Japan and France finance ministers urged Asia to include the Euro and Yen in a new post-crisis managed currency regime, arguing excessive reliance on the United States dollar had brought disaster."
However, the proposition meets early skepticism by other Asian nations, which have been scared into adopting the dollar as their reserve currency.
Japan has argued against the free flotation of currencies in developing countries as inappropriate, and is flogging an alternative to the dollar peg, which they feel was responsible for the Asian crisis. Let's face it though. In a world that appears to be up for division between two non Asian world powers, the dollar and euro, Japan no doubt feels left out as its own trading partners opt for the American idea of free floating exchange rate regimes, thus, leaving the Yen all alone on the continent, and rendering it incapable of effective monetary policy in the region.
The IMF response, or (rival) opinion, was religious but clear
The IMF argues that in most cases it is better for a developing country to adopt a free-floating exchange rate mechanism than to either peg their currency or to manage it. The reason, Mr. Kohler, managing director of the IMF, suggests, is that what the country needs to do in order to avoid a sudden test in international currency markets is almost undoable. He is referring to the tough policy decisions that need to be made in order to fix a currency against a standard such as the dollar. Apparently, under such a system there is no room for policy error.
Countries opting for such a system must pursue, unwaveringly, sound macroeconomic policies, and also need to be fully aware of the associated costs, including the possibility that extraordinarily high interest rates might be required at times of severe financial market pressure. Mr. Horst Kohler, managing director of the IMF, January 13, 2001.
Right there is a message to the Fed and US Treasury, whose vast policy web is primarily devoted to managing the greenback's value. Indeed, I will argue that a floating exchange rate system is preferable to a managed, or fixed currency regime, but that includes all currencies, including ours.
The idea is that currency markets will naturally punish countries that pursue weak economic policies (presumably for short term gain), and will reward countries that pursue strong economic policies (also for short term gain). But again, this assumes that exchange rate (dollar) markets are entirely freely trading, which is not the case today. It also assumes that there is a standard against which all other (inferior?) policies are measured.
This standard so far has been the dollar, for a long while now. But dollar policy has been arguably exploitive, abused, and perhaps now, has turned somewhat imperialistic. Furthermore, Mr. Kohler states that:
"…the IMF's largest member countries do have a responsibility to make the most of possibilities for effective policy coordination to reduce exchange rate volatility and risk of misalignments. "
But who is there to correct misalignments in the major currencies when the good times roll in their direction, and their owners seek out a little too much short term gain for their own good? There certainly needs to be a currency standard of some kind, whether we like it or not. The evidence is overwhelming.
Perhaps the Japanese and the Europeans will build a new "inflatable" currency standard, but somehow, this whole process of change is going to have to get very bumpy for both, the dollar and possibly the Euro, but especially the dollar, before the transition is complete. For that is the source of the global economy's current ills and poor expectation sets.
It is easy to be a critic
The solution for monetary policy makers everywhere is to peg their own "policy" to the way that the nation's currency interacts with the freely floating gold market price. This way, they can more easily monitor that elusive character of prices, influenced by a change in the currency's purchasing power, and adjust policy accordingly, maybe properly, and certainly with accountability. What an achievement that would be, and the Internet just might help us do precisely that. How? By encouraging the evolution of a freer press and thus, a freer flow of information.
Though, the question must be asked:
Can the Internet function in the private sector without the assistance of the government? Perhaps it is a relevant question in today's elusive profit picture.
The Point of Recognition
This point, therefore, cannot be too far away. But as long as currencies can still be "managed," so can gold prices. Thus, it is this argument, which is central to the gold debate, and it is when investors realize that the daunting task of managing a currency is a banker's version of utopia, that gold prices will soar, and never look back!
The only time that a group of people generally will all agree that there hasn't been any gold manipulation, is when they want to do a stock deal.