Dead Reckoning

By: Ed Bugos | Wed, Jan 31, 2001
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Some people believe rhinoceros horns have medicinal properties. We might doubt this, and study might prove we are correct in our doubts. But as long as people believe the horns are efficacious, the tools used to process the horns will be capital goods, and will fetch a market price that depends on the value assigned to the horns. The moment the last person stopped believing the horns had beneficial properties the tools would cease being capital goods and would lose all their value, unless they had alternate uses.
Gene Callahan

Our title today has a few undertones... it is actually a boating term, which the Captain will use when all systems are down in order to compute the straightest line possible to the desired destination. For Mr. Greenspan's sake, that line hopefully leads to higher stock prices. We won't argue with the supposition that the shortest distance between two points is a straight line, though a Quantum Physicist might. But we will argue the expected destination. We will argue that in this instance, the straight line leads directly to dollar obliteration. Having said that, it hasn't been a straight line so far.

Gold: The Consumer's Capital with a Stable "Marginal" Utility
Gene Callahan, an economics author for, wrote an essay last week titled, The Structure of Capital, where he showed that the value of a capital good is defined by its use, rather than by any visible physical, or intrinsic, characteristic that it may have. To be sure, he adds:

Its use is a function of the mind. Indeed, in Human Action, Mises says capital "is a product of reasoning, and its place is in the human mind. It is a mode of looking at the problems of acting, a method of appraising them from the point of view of a definite plan."

I would like to take the liberty to add something to Mr. Callahan's brilliant analogy. Clearly, since the market price of the capital good is dependent on the value (price) that the horns fetch then if by some bizarre sequence of events (outside of Mr. Callahan's control), the price of the capital good appreciates beyond the value of the horns then it ceases to become a capital good. Obviously, that statement is only true so long as it is not useful for the production of something with more value. By this very nature, then, the process of economic evolution is to a great extent potholed when prices are generally unstable - hypothetically of course because that just wouldn't happen today.

But the more persistent notion crossed my mind that within Mr. Callahan's paragraph perhaps lay the framework for the Fed's psychosomatic strategy to bury the gold standard. The idea that there are three dependent but hierarchical levels in which capital may be defined is stimulating thought on its own. To conclude that something with certain physical properties, for instance, can be defined as capital by virtue of those same visible properties one has to consider also, their usefulness in producing something of more value. There are two distinct levels right there, but Mises demonstrated that usefulness is also a state of mind. Thus, there is a mental dimension to capital as well. To us, this is equally interesting as it is disturbing. For, to think that there exists such a plan to manipulate the highest order of that hierarchy, borders on evil But to know that such a plan exists. That must be quite the load for anyone with a conscience.

Anyhow, consider first that gold isn't really a capital good. I am not talking about the factors of production that go into producing bullion. They are capital. In the case of the mining business, for instance, this form of capital has been effectively displaced, unless it has developed alternate "uses." We are talking about Gold bullion itself.

It doesn't have physical properties, save its conductivity, which make it useful to produce much of anything really, except jewelry. To that extent it is looked at as a capital good, because it is too scarce to be generally employed as a conductive agent. Yet, given a choice between a bar of gold and a basket of jewelry containing the same weight in gold - assuming that the other materials in the jewelry are additional in weight but have no marginal value - I don't know that I would choose the jewelry. It would only make sense to take the jewelry if it appealed to my particular unique set of individual tastes and preferences, for if it didn't, then it would have no use to me except for what I could get for it. Thus, the value added by the jewelry industry is incidental to my decision. The conclusion: it is arguable whether it is a capital good at all.

It is more reasonable to perceive gold as a consumer good rather than a capital good. In fact, that is probably why the government has a problem with it… because it is often inconveniently preferred to their legal tender. But consumer good is not entirely accurate either, for good implies it is consumed. So for the sake of clarity, let's just call it a consumer asset (capital).

Nevertheless, were the World Gold Council to choose to promote the jewelry industry, by chance, it might help to manipulate gold's efficacy in this manner. It doesn't need to alter the metal's physical characteristics, nor can it do anything about people's natural preferences for it. But it can try to alter your state of mind so that you perceive gold as an input, thus a capital good, rather than a final product of natural consumer preference.

Unluckily, Gold is not just any (consumer) asset but perhaps the ultimate consumer asset. For, it is a luxury; meaning that there is not enough of the stuff that anyone wouldn't want more of it. Sort of like today's money… it is hard to imagine that anyone wouldn't want an additional dollar (today's legislated money) in his or her wallet. Get the irony? Gold is a luxury largely because it is scarce relative to…

Thus gold, unlike most other metals, perhaps due to this relative scarcity, is able to hold its marginal utility theoretically indefinitely. Marginal is a word that Chairman Greenspan seems to favor these days, by the way, and it is in that word where you will best be able to explain gold's superiority over time. Time of course meaning decades, and in our case, perhaps even longer.

Now that we've established "some things," allow me to conclude that the conditions, which are precisely what make gold an important monetary asset, are twofold:

It is a consumer luxury, which happens to have a relatively determined marginal utility.

I believe that a regarded economist, Mr. Fekete, has debated this idea in greater depth in his essay, Whither Gold. It can be found at the FAME website -- Foundation for the Advancement of Monetary Education

Let me try to explain what I am getting at, it's important I think. The first question I would have for me is, "when are you going to rap this nonsense up Bugos?" Just kidding. But why do these particular conditions make gold valuable as a monetary asset? Follow me.

Unlike Rhino Horns, Gold Is Not A Con
The reason that inflation is confusing in the first place is that when looking at commodities such as oil, which is clearly a capital good of multiple orders, implicit in its value are many factors which influence price other than simply an expansion in the money supply. Thus, even if inflation (read: explosion) of the money supply was the root cause of "unstable" oil prices, because of the many ways it (the oil) is of use to us, so many other things may affect its price simultaneously. This is what makes the oil price a tough inflation barometer. However, as the economy slows down, thus reducing oil's value as a capital good - because it goes into producing so many things whose values must decline with the economy - yet, oil prices instead stay firm, or appreciate, perhaps it is really about time to reconsider the monetary aspect of the price equation.

Gold, on the other hand, does not have such a wide array of productive uses. So that when it does go up, appreciably, everybody should rightfully perceive an inflation problem. Furthermore, so long as gold does not appreciate in dollar terms, our other entire price, credit, and economic instabilities can legitimately be blamed on other things, rather than the nation's abusive monetary authority. If, for instance, gold prices rose along with energy prices last year, it is doubtful that we would need to listen to statements such as, "the Fed has got inflation under control," would we?

But Gold did not go up. Hmmm. I guess the Fed has inflation under control. That must be the conclusion, which is confirmed by the CPI. Triple, Quadruple, and Quintuple balderdash!! But we've already beaten that one to death in previous reports, haven't we?

Altered States
Gold has economic value simply by virtue of its relative scarcity, something that simply cannot be said for the dollar. In fact, it is even scarcer than oil, I think.

But it also has another value… the personal satisfaction that it brings to the consumer of jewelry, a high "marginal rate" of satisfaction, if you will. How many commodities can you think of where you would want more and more and more of them, in any shape or form? Diamonds perhaps, but if all heck broke loose, you may discover that the market is a little less liquid, owing to the awesome amount of diamonds actually in supply. The market is not only rigged, but control of the market is far too concentrated to function as a reliable unit of account, and thus, store of value. Silver? Sure, but not likely over gold. Besides, silver is primarily a capital good.

What of Platinum and/or Palladium? Sure, but then the Russians and the South Africans will rule the world. Having said that, both of these metals are also very much a capital good. Without their value (use) to us in building catalytic converters or fuel cells, their consumer appeal would pale in comparison to gold. I can't speak for everyone, but personally it does not matter to me how much more "valuable" platinum is today; I like my gold ring better. Maybe I just haven't made the mental adjustment necessary to value something according to its dollar price… bah, bah. Which brings me to another point - no not the Clintonites - that since the Fed SUPPOSEDLY has the most gold in the official sector (world), and with the threat of imminent inflation breakdown (dollar meltdown) looming, perhaps promoting the gold standard would be in their interest… I better stop there… sorry to get off on such a bullish tangent.

Anyhow, it is important to be clear about what we mean by a stable marginal (unit of satisfaction) utility. The reason is that despite these arguably superior conditions, and with the abundance of dollars being created every day by the Fed - more accurately, the American private sector financial system - gold markets are so quiet. There can be only three explanations for that:

    1. There is no inflation and all of the above is rhetoric
    2. Gold prices are directly manipulated, and
    3. There exists a deliberate misinformation campaign (include financial alchemy in here) aimed at persuading us that we do not need rhinoceros horns.

Number four could be both number two and three. In the case of our current dialogue, number three means that the campaigner's aim is to persuade you that gold is an ineffective inflation barometer, or that it is not the great monetary asset it once was, or whatever. This despite the fact that, publicly, most banks officially claim that it still is. Just that it is not as useful sitting around in a safety deposit box as it is employed as extremely cheap capital for whomever can write the cheque, in overused overprinted over-owned and junk credit backed dollars. Mr. Rubin must have been quite the salesman.

Anyhow, the point of the exercise is to illustrate that unlike rhinoceros horns, gold has natural values, which go beyond a simple "con." Thus, the effort to abandon a gold standard can only be successful in the end, if the monetary authority is a human(s) of the highest standards, principles, AND power, which needs no anchor. For otherwise, sooner or later, an inappropriate abundance of dollars relative to the scarcity of gold, will unavoidably result in monetary chaos when the day comes that the marginal utility of the dollar declines.

Please note that we have argued that this day has arrived in Declining Dollar Utility, written late last year, at about the time that the energy crisis in California was just beginning to escalate I think… yes they are connected.

The Fashionable "V" Bottom
In his congressional testimony last week, Greenspan argued that the real problem is that the surplus is going to wipe out the debt faster than anyone could ever imagine. Naturally, the next question was opened with the comment "nice problem to have…" of course, for the record, he is referring to the "unified" budget surplus.

Darn it. Now I understand why everyone runs around Washington using the word surplus as if it were real. They have invented an adjective to act as a disclaimer. Now they can lie to us with a straight face. For the word "unified," includes social security receipts, which are not really intended to go towards paying down the debt… otherwise we would be spending our social security fund today, wouldn't we?

Nevertheless, I certainly did come away (from watching the testimony) with some insight, however, into Greenspan's expectations, which will undeniably influence the FOMC's actions this morning. Greenspan made reference to a forthcoming "V" shaped recession, typically a term used to explain very bullish stock charts, as he pondered the most likely economic outcome for the months ahead. The trouble is that he is using the term in a forward-looking manner… but I suppose that he has litigation protection for that.

Still, what could he be talking about if he is not talking about consumption; for it is unlikely that monetary policy can do anything to stimulate production? So in this case, he must have some sort of delusion where he envisions manipulating consumption, so that it stays somewhat stable while the factors of production have had time to work off their excess inventories. In other words, while production first contracts and overshoots, it is then encouraged to rebound ferociously in order to meet back up with demand. I use the word ferociously deliberately to describe the use of his bullish body language.

Additionally, Greenspan sees the tax cuts as not possibly an immediate solution to our problems, but rather a hedge for a potential future where he may be wrong about this half-baked V shaped recession hypothesis… and we instead fall head first into a ravine, where consumption needs to be subsidized by fiscal means if it has half a chance at growing.. by then, he expects that the timing of the impact of the tax cuts would be right.

Clearly then, our own hypothesis remains intact: The Fed continues to fuel consumption, despite the heightened risks of inflation "breakdown."

The Bullish Case

Since 1985, there have been five periods in which the Fed reduced rates several times in a row. In four of those periods, the Standard & Poor's 500 Index began rallying within a month of the first rate cut and three months later the index was up an average 8.6 percent. Fed policy-makers lowered rates by a half-point on Jan. 3 in a surprise move, and the S&P surged 6 percent over the next three weeks. The central bankers meet Tuesday and Wednesday, and all 25 bond dealers that trade directly with the Fed expect another half-point cut, to 5.5 percent. Strategists say the market will benefit from such a move. ``You can feel with some added confidence that we have indeed seen the bottom'' for the economy and stock prices, said Brian Belski, chief fundamental market strategist at U.S. Bancorp Piper Jaffray in Minneapolis.
Deborah Stern, Bloomberg, Jan 29/30.

How can the market benefit from something that has already happened? The interest rate cut, I mean. Contracts on the Fed Funds rate have already moved to influence the other interest rate markets, and the money supply aggregates have literally exploded. The Bulls already got their second interest rate cut, and anything of bullish significance that might happen to "equities," as the result of an official move by the FOMC today, will be anticlimactic.

Short Term Yields
Short Term Yields

Bulls are generally convinced that people will (still) be willing to pay more for future earnings if interest rates are lower. This can be true if the inflation environment is relatively benign. Under such circumstances, people can have confidence in future private sector earnings power and the efficacy of monetary policy. Thus, the only question becomes adjusting the earnings multiple to a given level of interest rates. But such a benign macroeconomic backdrop simply does not exist today.

Still, even if it did, the assumption is that the interest rate is the only necessary valuation input. And we all should know that this is not true, especially our readers. But since we have already established this in Return of the Risk Premium just a few months ago, we won't waste much space on it today. Recall:

The Equity Risk Premium represents the additional return demanded by an investor to own equity over and above what is considered to be a risk free interest rate. It is used in valuation models as a discount rate to determine the current (present) value of a future stream of earnings.

Look again, Goldilocks has disappeared:

NASDAQ Composite
NASDAQ Composite
Commodity Research Bureau
Commodity Research Bureau

As a matter of fact, the circumstances today are much different than they were in say 1997 / 1998 or in the early nineties… much different. Bullish analysts (i.e. cheerleader types - as opposed to just analysts) will even conveniently agree, when they want to tell you why "this time is actually different."

Unfortunately, in the case of the Bloomberg report, they want to point out the similarities between the past and the present, revealing a strong bullish sentiment in the process. I suppose that there is nothing wrong with being an optimist, but the fact remains, that today, not only are stock prices still dear in a contracting economy. Not only have the capital markets already factored in, and spent, the next 50 basis points. But the changing macro environment has yet to be fully factored into the blue chip Equity Risk Premium, period.

Dow Jones Industrial Average
Dow Jones Industrial Average
NYSE Composite
NYSE Composite

But besides the less than certain macroeconomic backdrop, which can only be accurately reflected in a theoretical "natural" interest rate anyway, there are other inputs, which (should) go into computing the ERP, and which can affect earnings predictability… assumptions prejudiced by consensus perceptions for productivity, or the trade deficit, or technology spending, or even government surplus projections. The list of potentially wrong assumptions is so long that it has become boring. So the relevant question on this argument is, how confident are investors that the earnings will be there, relative to say, how confident they were in the first quarter of 2000?

Zero Tolerance for Austerity!
Isn't it the truth? Some sectors of the US equity markets have improved on their poor technical chart conditions… meaning that they have demonstrated, or printed, some meaningful will to move higher. Market breadth (of participation) too has improved, somewhat. This is quite amazing actually, if you consider the extent of the damage done to the economy and the more speculative capital markets. The improvement is certainly making us sweat a little about our market call, last week, for a 2000 point Dow drop. However, after looking at Tuesday's action, we remain steadfast…

The reason, as we've already mentioned, is that while the market has fully discounted the next rate cut, it hasn't yet discounted our inflation hypothesis. Specifically, how a rate cut will help to "aggravate" that outcome. But it is more than that. The longs have bid up the wrong sectors… financials, banks, semiconductors, telecoms, etc. Essentially, over the past month, investors have expanded the multiples of stocks, which will clearly benefit from lower interest rates in a benign economic climate, but which are most likely to underperform in an inflation breakdown. Thus, we cannot reasonably expect any extension of this rally to be sustained; regardless of how low interest rates may go so long as dollar inflation reigns.

Over the past few days, and especially on Tuesday, the bulls have added a few short-term plays into the fray. Alcoa's little run (Tuesday) was obviously a speculative welcome home coming parade of some kind for the inauguration of Mr. Paul O'Neill to his new role as Treasury Secretary. But it left the stock far short of a clear primary trend reversal… meaning that the primary trend is still down, or neutral at best. Furthermore, while O'Neill will undoubtedly be a benefit to Alcoa's shareholder's in his new role sometime in the future, the stock trades at 20 times earnings today and besides, Mr. O'Neill has other priorities on his agenda. Such as persuading congress that they should jump all over Bush's tax cut plan even while dollar inflation is breaking out all over the place.

Alcoa Inc.
Dupont E I DeNemours Co.

General Electric
General Electric Co.

Minnosota Mining and Manufacturing
Minnesota Mining and Manufacturing Co.

Incidentally, the top nine Dow performers in Tuesday's rally turned out to be the cyclicals and commodity stocks - generally the issues, which should outperform in an inflationary environment, and generally the issues we would be bullish on in such an environment. But their average (unweighted) price earnings ratio is 20, and arguably at the END of a long economic expansion when their optimum earnings power ought to be fully represented in the data. General Electric sports the healthiest of these at a whopping 36 times earnings. Furthermore, five of the nine issues are still unquestionably controlled by a primary bear market trend, while three have challenged their primary bear controls at best, leaving only one in a decided primary up market: Minnesota Mining & Manufacturing. Would you believe it? Maybe we're onto something after all.

So if the bulls have already spent their liquidity as well as their sentiment, the FOMC is going to have to give them "more" than 50 basis points if a liquidation of blue chips is to be averted. Else, we remain undeterred in our call for a 2000-point drop in the Dow Industrials.

More than a half point rate cut? I doubt we want to make a call like that, and additionally, how the equity and bond markets would react to such a bold move is not clear.

However, we know what to do
To be sure, this is a silly game for Wall Street, because if you ask us, the real play is in oil, and other commodities. What do you think that oil prices will do on a rate cut like that? Yee-hah!!

Weekly Oil Futures - 2 Years
Weekly Oil Futures - 2 Years
Weekly Copper Futures  - 2 Years
Weekly Copper Futures - 2 Years

Yeah, c'mon, gee... new economy or OIL? What does your gut tell you? Do not forget to take into account the fact that Phelps Dodge recently threatened to shut down some production due to the prohibitively rising cost of power. However, they are on hold to see how the situation plays out, for the moment. Wow, suddenly there could be a play on copper too… how viciously shrewd. Remember how plentiful it seemed that that commodity was only a few years ago? My, things may change fast. What about something a little more luxurious; like a commodity that will surely be scarce as the need for technology to advance continues?

Weekly Palladium Futures - 2 Years
Weekly Palladium Futures - 2 Years
Weekly Platinum Futures - 2 Years
Weekly Platinum Futures - 2 years

If we had to be in the equities before the rate cut, it would be on the short side, although if we had a choice we would be entirely out until after the rate cut… BUT, we would hedge our trade with a long position in the CRB, and especially in gold, "prior" to the rate cut.

Gold prices were perky today on a very weak consumer confidence report... an odd development in its own right. The dollar is likely to react negatively regardless of whether they lower by 50 or 100. We are rapidly nearing the point of recognition for our inflation hypothesis. And finally, the charts for both Gold and Silver are looking quite interesting… note the nine-month declining wedge controlling the gold price: Thus, if I had to put my money anywhere, it would be on a bet that gold prices are about to break out of this wedge, aggressively.

Weekly Gold Futures - 2 Years
Weekly Gold Futures - 2 Years
Weekly Silver Futures - 2 Years
Weekly Silver Futures - 2 Years

But, what about the government's resolve?
Are we suggesting that investors should bet against the government's ability to contain the energy crisis in California? Yeah. Are we suggesting that investors should bet against the government's ability to hold the stock market economy together? Absolutely! Especially since they (the government) are the cause of both problems. Allow us to try and make the connection between all of that, and what is happening in California at the moment.

"We're doing our level best, there are forces in play over which we don't have control now, the form of deregulation that California passed five years ago, " Governor Gray Davis.

Oh brother. Those (regulatory forces) are the only forces you have control of pal. Forgive us, but it is fun picking on the politicians, because they are a non-stop source of irony and credulity.

There is no point in blaming deregulation when the source of the problem is a quadrupling of natural gas prices over 12 months. What is the source of that imbalance? An overheated economy? But, I thought we were in recession. Suddenly we got a shortage of gas, hmmm. Sure there is a real estate boom in California, which has been building natural gas utilities into about three quarters of the newly built homes on the west coast. What has fueled the boom though? Productivity and technology - not likely.

Certainly, that is why the money went there, but who supplied the money and how much of it did they supply? It's easy, really: the Fed, the US banking / financial system, and the various GSE's (Government Sponsored Enterprises)… truck loads… that's how much. In fact, we are witnessing the greatest monetary inflation history has ever seen!

There "is" a relationship between gas prices and oil prices. It is conceivable that if oil prices did not rise to $35, but rather stayed at $10, there would be a much smaller impact on the gas markets. By the way, wasn't the economy stronger from late 1999 to the first quarter of 2000 than it is today? Yup. Yet gas prices were 1/3 of what they are now. Yes, it has a lot to do with oil prices, but what caused oil prices to rise so sharply in the first place? If you cannot answer that by now, please reread the prior paragraph.

Thus, Mr. Greenspan's cowboy Fed policy ought to obviously accelerate both problems… energy and economic. I would be surprised, personally, if he were to make such a bold move this week (bold meaning greater than a half point). But bold he is going to have to be.

Speaking of Mr. Greenspan:

Wall Street Experts... we just throw you off of the plank and see if you can swim. If you can, or even if you can't but can keep your head above water for 30 seconds at a time, we'll promote the heck out of you so that you will intimidate every other shark in the neighborhood. We will do this by giving you credit when you don't deserve it, and the more you jump up and down for our cause the more credit you'll get. This virtuous credibility cycle will then escalate our mutual influence and wealth, but when the going gets a little tough, we'll blame the whole mess on you because we gave you the opportunity to look like a clown in the first place. C'mon, don't miss your opportunity… Uncle Al needs you! Good Luck.


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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