Can the Real Bull Market Please Stand Up?

There is nothing more bullish for gold than a situation where the central bank refuses to acknowledge that it is pouring gasoline on a raging fire. Forget the dollar, and oil. Those were just interim preoccupations. The newest addition to the Agora Financial family, Ed Bugos, explains…

Remember that old Wall Street maxim, "Don’t fight the trend"?

Now remember another one, "Don’t fight the Fed"?

Well, what happens when the Fed fights the trend, as it has been recently? Which axiom to believe?

Historically, the Fed loses that fight until the trend is ready to turn back around. Admittedly, the central bank’s inflationary policies will likely help this occur at a higher nominal dollar value than otherwise.

Nevertheless, the historical odds favor the trend over the Fed when these two maxims collide.

But putting aside my autistic wisdom for a moment, let’s consider what the Federal Reserve is doing for the trend in gold prices – a trend, I am loathe to inform you, which it is not fighting.

Let me sum it up: the trajectory of this bull trend shifted north when Bernanke took the helm of the Federal Reserve System, and that the policies pursued by the Bernanke Fed have confirmed the investment thesis driving the bull market in gold. As one pundit recently noted during a Bloomberg interview, "You gotta go with the inflation theme… it’s the only thing still working."

After upping the size of its new term auction facility from $60 to $100 billion this weekend, the Fed revealed another innovative tool that might help it manage liquidity in the banking system.

The new facility, the Term Securities Lending Facility (TSLF), will offer up to $200 billion in Treasury Securities to primary dealers in exchange for a wide variety of collateral the Fed has never before accepted, including private label mortgage securities. It also eased swaps with other central banks.

The controversy is that although the Fed has been allowed to accept mortgage backed securities as collateral since 1980, it has never outright bought them, and only recently enacted legislation that allows it to actually monetize them – which means to buy them without having to sell other assets.

Gold bugs have followed the Fed’s legislative changes with interest. This move should not surprise any of them, but it does hold a special significance in its long-term implications, and for gold prices.

And even though the Fed hasn’t expanded bank reserves or the monetary base much since August, it is helping the banking system postpone an increase in reserve demands triggered by criteria built into the Basel II framework, a generally accepted model for capital adequacy standards. By boosting the quality of bank reserves, even if temporarily, the Fed hopefully won’t need to increase the quantity of bank reserves, which have been sufficient to fuel an $800 billion expansion in the broad US credit aggregate, MZM, since August. That is 11%, or 15% year over year. The highest rate since 2002.

That is a bullish recipe for the precious metals. There is nothing more bullish for gold than a situation where the central bank refuses to acknowledge that it is pouring gasoline on a raging fire.

Forget the dollar, and oil. Those were just interim preoccupations.

The real bull market is about to stand up.

If gold prices are going to continue to drive through $1000, they are going to do it because the central banks are all inflating madly at the worst time. This means that a good old-fashioned bear market on Wall Street is sufficient to keep central bankers’ collective petal to the medal, and sustain the gold bull.

So far, the precious metals stocks have bucked the general stock market trend since August.

This is as it should be, and it is impressive because by most counts gold stocks are quite expensive relative to today’s gold price. But, investors are complaining about the underperformance of those stocks relative to gold, and also about the lackluster performance of their junior mining assets, which haven’t participated in the precious sector rally at all since August – when the current leg started.

There are a few explanations for this.

Perhaps John Embry said it best, at a gold conference in Vancouver recently, when he remarked that gold shares sometimes act like a bet on gold, but sometimes they just act like plain old shares.

We should leave it at that…however, that is not like me.

Historically, I have found that gold shares are susceptible to market declines, except occasionally during a major bull market advance in gold, when they tend toward counter-cyclicality – the more so as the bull market progresses. They will still fall during stock market panics, as all shares do, but they are likely to come back harder and hold their trends better. Still, since 2004, I’ve held the position that, as an asset class, gold shares would not outperform gold prices for the remainder of the primary leg.

I continue to think that, with the qualification that we are talking about the average gold stock.

Junior markets are wired differently. They do not correlate that well with the underlying commodity trend in the first place. In my experience, they correlate better with market attitudes toward risk.

Junior and small cap markets have never fared well in a general market meltdown because they are typically risky assets, and in a selling panic the crowd is averting risk.

The larger capitalization precious metal producers are different. The reasons for this are sound. But as a rule, speculative assets do well when the gambling environment is friendly.

However, within the small cap resource sector there will invariably be exceptions. It remains to be seen if the junior gold miners will be able to buck the general market trend, but there is a good chance they will. Many of them are cheap now, and the supply fundamentals for gold are tightening.

Production from many gold producing regions of the world is currently constrained by power shortages; and rapidly inflating development costs are causing the postponement of several otherwise promising development projects around the world. Meanwhile, gold producers need reserves!

The large cap producers are on the hunt for sound mining assets. And they aren’t going to be discouraged by a 20-30 percent drop in gold, or stock prices.


Ed Bugos
for The Daily Reckoning
March 13, 2008

P.S. I’m lining up several potential takeover targets for my first issue of Gold & Options Trader. These include small cap gold miners that have either just finished developing a new mine or soon will be, or whose assets are otherwise overlooked. And we’ll be publishing option strategies to profit from swings in the large cap miners too. Regardless of which way the markets go, I’ll show you how to profit from trend changes.

Tune into my letter to find out when it will be time to get out, or insure your gold stock portfolio.

Before starting up Gold & Options Trader, Ed came straight from the North American heart of the gold market – Vancouver’s Howe Street. During the nasty commodity bear market in the ’90s, Ed still guided his clients to gold profits in Argentina Gold and Arequipa, both of which became buyout bait for Barrick. He also founded the "Bugos Gold Stock Index" which included no more than 10 stocks at any time. From December 2001 to May 2006, his index gained 200%, averaging 30% compounded annual gains. And his index was composed solely of mid to large-cap producers, not the exploration of junior companies.

Maybe we’re wrong. If yesterday illustrated the essence of this market, we are definitely wrong.

Our hypothesis is that the fed’s efforts to inflate will show up more in the gold market than in the stock market. That – and an instinct for self-preservation – is why we’re long gold and short stocks. Stock prices depend, ultimately, on earnings. Gold’s price depends, ultimately, on inflation. The feds can make more cash and credit available…but they can’t wipe away all those bad debts, which are hurting earnings. That is, they can increase the rate of inflation…but not make businesses more prosperous.

We’re witnessing a War of the Worlds – between inflation and deflation. We don’t know which side will win, but we’re betting that while inflation favors gold, deflation has it in for stocks.

But what’s this? Yesterday, the Fed promised inflation – big time. It said it would pump in an extra $200 billion to fight deflation. Europe and Canada said they were in too – for another $45 billion.

Where does all this moolah come from…savings? Don’t make us laugh, dear reader. It comes "out of thin air" as Keynes once said.

And what is the effect of pulling money ‘out of thin air’ and putting it in the money supply? More dollars…more monetary inflation.

According to our hypothesis, investors should see what’s coming a mile away. They should have jumped to buy gold. Instead, they bought stocks. The Dow roared up more than 400 points. Gold barely went up $4.

So go figure. Still, oil hit a new high over $108. And sometimes it takes investors a little while to put 2 and 2 together. So, let’s see what happens tomorrow before we come to a conclusion.

Besides, stocks may have gone up yesterday anyway; a rally was probably overdue. Commodities are at an all time high. Oil too. And more and more evidence comes to us that consumers are feeling squeezed…and forced to cut back on spending – which will further hurt business earnings.

"Surging cost of groceries hits home," says the Boston Globe.

"Paying at the pump, in a big way," says the New York Times. "Record fuel prices blow budgets," adds the USA TODAY.

"401(k)s tapped to save homes," it continues.

While rising prices pinch family budgets, falling asset prices pinch everyone. Most of the economy seems to be deflating. Housing is going down. Household incomes are going down. We’ll have to wait a few days to find out what direction stocks are going.

The big picture still shows the same scene: America is getting poorer. Its money buys less stuff. Its working people earn less money. Its assets are worth less than they used to be.

"This thing is not about a recession or not a recession…and it’s not about inflation or deflation. It’s about re-pricing the U.S.A., downward. Sell America…sell its money…sell its stocks…sell its property…sell its politics…sell its economy…sell its I.O.Us. Sell it all," said a friend over the weekend. "It’s clear to me that America’s best days are behind it. The United States has had a disproportionate share of everything for too long – stock market valuations…the world’s savings…the world’s energy…the world’s calories…the world’s military power. That’s what is changing. The world is readjusting…it’s not getting out of balance; it’s getting back in balance. It will be a world where the United States plays less of a role…and takes less of the world’s resources."

He is probably right. Asia is growing much, much faster than the United States. Wages are going up 10% per year in China…15% per year in India. Stock markets are booming. GDP growth in many foreign countries has averaged about three times the U.S. rate for the last ten years. Now, with the U.S. economy not growing at all…Asia is racing ahead.

We have no particular quarrel with this. America has enjoyed an extraordinary run of luck. She had cheap energy…history’s most powerful military…and the world’s reserve currency. Now she has the world’s biggest debts…its highest deficits…and the most colossal financial problem ever. In short, it has passed its I.O.Us out all over town and now owes more money to more people than anyone ever did. It now has more financial commitments any nation has ever had (with a financing gap of $60 trillion – not including the cost of the Iraq War…which is expected to be as much as $5 trillion)…and has a competitive disadvantage against much of the rest of the globe. Asians make things cheaper. Europe makes them better.

How did such nice people get themselves into such a mess? Are Americans stupider than other people? Are they lazier? More reckless…more feckless?

Nah…we’re just victims of our own good fortune. We had it too good for too long. A unique set of circumstances allowed Americans to borrow and spend more than anyone ever could before…and so they did.

As an aside, this turn of events for America is where we got the idea for the title of our documentary film, I.O.U.S.A. We are hoping to have an exciting update for you, dear reader, in coming days. Stay tuned. In the meantime, check out the film’s website.

*** "It’s the credit bubble, stupid," says Forbes.

Yes, that is what it is…a credit bubble that is deflating. The tide is going out, as Warren Buffett puts it. Now we see who’s been swimming naked. Not a pretty sight. So ugly, in fact, that people can’t stand to look.

"Fed takes boldest action since the Depression," says an article in the London Telegraph.

Yes, dear reader, our leaders are doing something. Now, we just wait to find out how much damage they have done.

The hardest thing to do is nothing.

But in matters of politics and money that is usually the best thing to do.

As we’ve pointed out many times, nothing gets no respect. "Do something," come the cries from all corners. Even those who should know better implore public officials to take action:

"When a man is having a heart attack, you have to intervene…you can give lectures about his diet later," they say.

But the U.S. economy is not dying. It is merely adjusting to a new set of circumstances. The consumer is tapped out. Without more income he cannot increase his buying. And without more spending, the consumer economy stalls…and contracts. No, don’t even think of lending the consumer more money – he has too much debt already.

This is an election year and the politicians want to dodge a contraction in the worst possible way. What would be the worst possible way? Easy – add more debt. That is precisely what the Bernanke Fed is doing. Yesterday, they offered another $200 billion to their friends in the banking industry – lent against the trashy collateral that no one else would accept. Now, the Peoples’ Bank of America – ultimately, the taxpayer – will be holding the bag.

*** And Bryon King sends us this note:

"While Ms. H. Rodham-Clinton and Mr. B. (No Middle Name) Obama battle out over who will be the Democratic Party nominee for U.S. president, there is another Great Smackdown occurring within American politics.

"This other match – a true eye-gouging, ear-biting cage-match by any standards – may well determine the success or failure of the next U.S. president, no matter who is elected next November. (Presumptive Republican nominee John McCain has admitted one of his own limitations, ‘I don’t know as much about economics as I should.’ He gets points for honesty, if not candor.) And this other knock-down, drag-out competition is taking place within the marbled hallways of a certain institution located prominently on Constitution Avenue in Washington, DC, just across from the Lincoln Memorial.

"It appears that a certain Mr. Richard Fisher, of Dallas, Texas (and by occupation, president of the Dallas Federal Reserve Branch) is lobbying for the job of ‘Successor to Ben Bernanke.’ That is, Mr. Fisher wants to be the next Chairman of the U.S. Federal Reserve.

"The current course of U.S. monetary policy is not sustainable. The Bernanke monetary policy is wrecking the value of the U.S. dollar. The charts don’t lie. Inflation is rising. The prices for gold and silver are soaring, as is the price of oil. The dollar is at historic lows against the euro, as well as numerous other world currencies. U.S. import costs are exploding. And despite his academic credentials as a historian of the 1929 crash and Great Depression of the 1930s, Bernanke is simply in over his head.

"We may be witnessing some macabre and tragic drama scripted by the gods. And in this play, it may be the unpleasant role of Mr. Bernanke to lower interest rates to the point where he must take the sword. Bernanke may or may not understand that he is the star of the R-rated version of a snuff film. Bernanke’s sad destiny is – paraphrasing the words of Gen. George Patton here – to grease the treads of someone’s tank. The best that Bernanke can hope for is a relatively dignified and hasty departure from the Fed, with perhaps a final limo ride in which he is not garroted like in the chilling scene that occurs at the end of The Godfather.

"No matter what, and in the best of possible outcomes, Mr. Bernanke will not escape the Circus-Circus atmosphere of a summary dismissal from his current job. His trip to the unemployment lines will be heralded by calls from Congress for his removal, if not his head.

"This is all another way of saying that over the long term the world’s bond markets cannot afford – and will not tolerate – the current sordid state of monetary affairs. Bernanke is costing a lot of people a lot of money. He is bad for business. And so Bernanke as Fed Chairman cannot last much longer. He is going to go, sooner or later. Probably sooner.

"It is the nature of the position of ‘America’s Central Banker’ that someone will have to take Bernanke’s place. At 81 years of age, Paul Volker is probably too old to retake the job he held from 1979 to 1987. And Volker may not be ready for a replay of his previous efforts, marked by angry mobs burning his figure in effigy. (And second acts do not play well in Washington D.C. Look what happened to Donald Rumsfeld during his rerun at the Department of Defense.) So someone will have to step up to the plate, take the seat as Fed Chairman and start pulling triggers. Someone will have to call a halt to the serial interest rate reductions that have occurred on Bernanke’s watch. Someone, in fact, will have to raise interest rates and squeeze the monetary poison out of the U.S. economy – and by extension the connected world markets.

"Someone will have to administer the medicine that both the United States and the world requires. Someone will have to do the dirty work. Someone will have to take the hit – ‘for the team,’ as they say down at the football pitch. Richard Fisher appears to be volunteering for the job. Good luck, Mr. Banker-Man. You are going to need it. Really. You are going to need a lot of luck."

Until tomorrow,

Bill Bonner
The Daily Reckoning