The Gold Bug: June 2012

Tuesday, June 26, 2012

Greed is good.

By Scott Silva

6-26-12

“Greed, for lack of a better word, is good.” So said Gordon Gekko, the iconic corporate raider in Oliver Stone’s cynical 1987 film Wall Street. Michael Douglas won an Academy Award for Best Actor for his role in the film, now a classic. In the film, Gekko is ultimately imprisoned for securities fraud after years of benefiting from insider trading. Today, many liberal legislators and left-wing politicians associate Wall Street traders and investment bankers with the criminal activities of Gordon Gekko, the fictional film character. Certainly the Occupy Wall Street protesters believe Wall Street is the seat of corporate greed and corruption. Some US Senators conflate securities fraud with speculation, frequently referring to Gordon Gekko, excess and greed in speeches designed to vilify speculators, who after all, “caused the financial meltdown” or, “caused $5.00/gal gasoline prices” with their wonton, unbridled greed.

But speculation in the commodities markets is not illegal. Nor is it immoral. In fact, speculation is integral to operation of free markets. There is a legitimate role for market speculation in efficient markets. Without market speculation, prices would be less stable and price discovery more difficult, making markets less efficient. For example, if there were no speculators in the pork bellies market, the market would consist of producers (hog farmers) and consumers (butchers, and those who prefer to carve up their meat themselves). With just two participants in the market, the market would be thinly traded, leading to large spreads between bid and asked, which distorts prices, and makes capital investment less efficient. As a market participant, the speculator adds liquidity (risks his own capital) and provided a competitive bid which narrows the spread, making the market more efficient for all participants. Because there are two sides to a speculative trade, either the long position holder or the short position holder will benefit from price changes over time.

Usually, speculation in a particular market has a dampening effect on price volatility, but there have been periods of “irrational exuberance” where prices are bid up in exponential fashion, creating a market bubble. Speculators may participate in the development of a market bubble, as they did in the real estate market boom of 2000-2008, but it takes more than speculation to cause a market bubble. In the case of the US real estate bubble that burst in 2008, decades of easy money and government intervention in the home mortgage industry via the Community Reinvestment Act laid the foundation for the irrational boom and its ultimate bust.

Recently, speculation has been blamed for high gasoline prices. “The oil speculators have bid up the price of oil, so you are now paying $5.00 per gallon at the pump!” complained a US Senator who proposes to ban speculators from trading oil futures. “Only producers and commercial consumers who need to hedge should be allowed to trade oil futures contracts,” say proponents of strict regulation of the oil futures markets; “Speculators are greedy, and greed is bad.” But studies show that oil prices have increased steadily since 2000, with commercial and non-commercial (speculators) holding net long into the extended bull market for oil. Even during the period of strict regulation and position limits on the commodities futures market, prior to the Commodities Futures Modernization Act, oil prices tended to climb higher year after year.

Although speculators have represented a growing percentage of open interest since 2003, the Commodities Futures Trading Commission (CFTC) concluded in its own investigation of the oil futures market that there is no evidence that the market was influenced by the trading behaviors of any large group of participants. In fact, CFTC chairman Walter Lukken told a committee of the U.S. House of Representatives in 2008 that CFTC analysis “did not find direct evidence that speculation was driving up (commodity) prices.” The fact is, global the oil market was tight, leading to the peak price of WTI at $147/bbl in mid 2008. The futures price was a prescient leading indicator.

If speculators did not cause the bubble in the oil market, what did? One explanation that makes sense is the weakening Dollar. Because oil futures settle in Dollars (or physical delivery), it takes more Dollars to buy a barrel of oil, for a given supply, when the Dollar is weak. Conversely, the stronger Dollar purchases more barrels per Dollar, driving down the price in the global market. The value of the Dollar has been trending down ever since the Federal Reserve has been printing more of the stuff in the name of US economic stimulus. It is the time-tested economic principle known as Gresham’s Law that bad money drives out good. Printing more money out of thin air debases the currency and devalues Dollars in circulation.

We can see the inverse relationship of oil (West Texas Intermediate, WTI) and the US Dollar Index (USD) in the chart below. WTI peaked just as the US Dollar bottomed in 2008 just as the Federal Reserve added the first $700 Billion of the $3 Trillion it would add to its balance sheet under its economic stimulus policy. The anticipated effect of spurring the economy into robust recovery has proved elusive. But there are unintended negative consequences of the Fed’s money printing spree, which include higher prices for commodities. As we know from Milton Freidman and the recently departed Anna Schwartz, may she rest in peace, inflation is always and everywhere a monetary phenomenon.

We also know that the price of gold reflects the strength of the Dollar. The Dollar’s drift from 2002 to 2008 helped propel the price of gold up over $1200/oz. Of course, there are other factors that contribute to gold’s rise. Gold is the traditional safe-haven asset that investors seek out in times of economic uncertainly, turmoil and war. Gold has intrinsic value, and it acts as a store of value. Unlike fiat currency, gold maintains its value and is recognized as viable collateral for transactions in markets around the world.

Today, oil prices have subsided a bit from the highs of over $110/bbl earlier this year. WTI is now trading down below $80/bbl with no added supply. Some analysts believe that the war premium has been wrung out of the price. Iran is no longer openly threatening to close the Strait of Hormuz. Maybe so, but the primary cause is softer demand. Double dip recession in Europe, a slowdown in China and the continuing slow-motion, no-growth, jobless recovery in the US has dampened demand for energy. And by the way, the Large Speculators have been cutting back their long positions on WTI and adding short positions; last week’s Commitment of Traders report showed bullish sentiment for oil has dropped to 63% down from 96% in February when WTI was trading near $110/bbl. No one seems to complain about speculators when prices go down.

Gold is also trading below $1600/oz. But more poor US economic data is coming for sure, and the Fed will jump in with more quantitative easing, adding more to its balance sheet which will further devalue the currency. So, in today’s market, take a page from Gordon Gekko’s playbook. Buy, buy, buy gold. Because, as we all know, “Greed is good.”

Responsible citizens and prudent investors protect themselves and their wealth against the ambitions of over-reaching government authority and debasement of the currency by owning gold. Gold is honest money. Investors from around the world benefit from timely market analysis on gold and silver and portfolio recommendations contained in The Gold Speculator investment newsletter, which is based on the principles of free markets, private property, sound money and Austrian School economics.

The question for you to consider is how are you going to protect yourself from the vagaries of the fiat money and economic uncertainty? We publish The Gold Speculator to help people make better decisions about their money. Our Model Conservative Portfolio has outperformed the DJIA and the S&P 500 by more than 3:1 over the last several years. Follow @TheGoldSpec Subscribe at our web site www.thegoldspeculatorllc.com with credit card or PayPal ($300/yr) or by sending your check for $290 ($10 cash discount) The Gold Speculator, 614 Nashua St. #142 Milford, NH 03055

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Tuesday, June 12, 2012

Eurobomb Ticking Down, II

By Scott Silva

Editor, The Gold Speculator

6-5-12

Last January, we warned readers of these pages of the “Eurobomb Ticking Down”, which forecast financial chaos across the Eurozone would come as the result of continued deficit spending, massive accumulated sovereign debt and growth of entitlement program spending to unsustainable levels. http://www.kitco.com/ind/Silva/jan182012.html

Today, the G7 is holding emergency meetings to deal with the imminent collapse of Spanish sovereign debt in the bond markets, even as Germany considers funding a bailout package for Spain, or possibly changing its position in favor of the Eurobond solution to the regional banking crisis. As Papa Hemingway once observed, bankruptcy happens two ways, “Gradually, then suddenly.” Today, Treasury minister Cristobal Montoro said that at current borrowing costs financial markets were shut to Spain. If the bond market were suddenly no longer available to Spain as it struggles to refinance its debt, without restructuring, Spain’s financial system would collapse, pushing its battered economy further into recession, then likely, depression. Already, one in four is out of work in Spain. Yet the government is unwilling to accept terms of any EU rescue plan.

Greece is faring no better. Standard & Poor's announced today there is 1/3 chance that Greece will exit the Eurozone in the coming months, following the elections on June 17^th. The credit agency further stated a Greek exit would “seriously damage Greece's economy and fiscal position in the medium term and most likely lead to another Greek sovereign default.” Another Greek default would impact other Eurozone economies which would also face credit rating write- downs-- a vicious downward spiral.

The emergency conference call of G7 members today is not likely to result in immediate action. The G20 is scheduled to meet June 18-19, immediately following elections in Greece. A major topic will be the path to financial stability for the Eurozone. All G20 members, including the US and China have a stake in the summit outcome.

But the bond market is not shutting Spain out. At least not yet. Yields for Spanish 10-year notes are coming down in today’s trading. Apparently, the bond vigilantes did not get the Montoro memo. Although rates for Spanish 10-year note have risen steadily and approached the 7% danger zone leading up to the G7 meeting, yields declined 1.3 basis points to 6.4% in today’s trading. The market is discounting a coordinated effort by the ECB, EU and the IMF to stabilize the Eurozone and keep it intact. Last week, the EU offered to extend the deadline a year to 2014 for Spain to bring its deficit down to the EU limit of 3% of GDP. The Commission has also suggested that the ESM could provide direct funding to Spain, although that measure would require a change to the existing treaty and ratification by all 27 members. Even if these life-line measures were adopted, they may prove only to delay inevitable default.

Some near term relief may come from the ECB. Many analysts expect the ECB to cut its refi rate below its current 1% level within the next few weeks. A near-zero interest rate policy would ease pressure on those countries most in need of cheap refinancing. The ECB could also opt for another injection of liquidity into the entire region via long-term refinancing operations (LTROs), or some old fashioned bond-buying. But these steps would also firmly establish a liquidity trap in which no amount of added liquidity to the banking system provides marginal output. This is the problem with the Keynesian obsession with too much money. It is simply impossible to print your way to prosperity with more and more fiat currency. But that is precisely what progressive central bankers tend to do when facing an economic downturn. Apparently, the urge to ease is powerful and overwhelming.

But intervention fails. It has always failed. And it will always fail. Fed intervention failed to reverse the economic slide in the 1930’s. In fact, according to Friedman and Schwartz, Federal Reserve actions deepened and extended the Great Recession. Today, near-zero interest rate and quantitative easing by the US central bank has failed to reverse the economic slide of the Great Recession. And the ECB has failed to ignite any economic recovery in the Eurozone. For example, the leading European economies, Germany, France, Italy and Spain account for 77 per cent of total Eurozone GDP, but in the past four quarters, Germany posted average quarter-over-quarter growth of 0.3 per cent, yielding an annualized rate of expansion of just1.2%, while most of Europe remains in recession. France posted average quarterly growth of just 0.1 per cent in the year up to April, an annualized rate of expansion of just 0.4 per cent. France recorded zero quarterly growth in 1Q2012. Spain and Italy have been a drain. Spain is officially in recession with an average quarter-on-quarter decline of 0.1 per cent since the second quarter of 2011. Italy is in its third consecutive quarter of negative growth, with an average quarterly rate of minus 0.35 per cent over the year to April 1. Utterly underwhelming.

So what does the continuing saga of the Eurozone debt crisis mean for investors? Well, for one thing, the markets will remain volatile for some time yet. There will be more gnashing of teeth as European welfare state economies contend the realities of long term unsustainable deficit spending and oppressive tax regimes. The options for countries with 150% debt/GDP become fewer and worse. The central planners will resort to ever more debasement of the currency at the expense of individual purchasing power and increased demand. Weaker demand in Europe for American exports will dampen the sluggish (and jobless) US recovery. Funds will flow out of the Euro and out of stocks and into “safer” assets and currencies such as the Dollar, the Swissy and gold.

We can see that the concerns over the Euro crisis and also concerns over an uptick in the latest US unemployment rate have caused the ‘Fear Index” for stocks to jump. The “Fear Index” is the CBOE Market Volatility index, which trades by the symbol VIX. The VIX is quoted in percentage points and translates to the expected movement in the S&P 500 index over the upcoming 30-day period, which is then annualized. The VIX has an inverse relationship to stock prices. That is, when the VIX trades up, stocks tend to decline. The higher the VIX climbs, the lower go stocks. The VIX is indicating we are in for some more volatile times in stocks.

We can also see that gold has outperformed the S&P 500, and is less volatile than the broad stock index. Recent volatility has erased earlier gains of the S&P 500. The VIX is portending rougher weather ahead for stocks. At the same time, gold has regained some luster. Gold will climb higher if the ECB decides to resume its bond-buying program.

So where will the smart money go as the European debt crisis plays out? The smart money will buy gold. Gold is a store of value. Gold benefits from government intervention in the credit markets. Gold increases in value as new fiat money is printed. Gold appreciates in times of economic uncertainty. At today’s prices, gold is a bargain.