When the Logic of the Bull Market Suddenly Seems Illogical

Nothing much to talk about in the markets yesterday.

We had been expecting a bigger sell-off in the price of gold. The metal went down, about $300 if we recall correctly, but not as much as we expected.

In the last major bull market in gold, in the ’70s, the price declined by about 50% before going on to set a new record. The pullback in 1974 caused investors to question the premise of the whole bull market. Many dropped out and missed the big payoff.

Markets always test their admirers. The old-timers — such as Richard Russell — refer to the “50% principle.” A bull market can be expected to retrace as much as 50% of its gains…before going on to fulfill its destiny. If it goes down more than 50%, however, the bull market may be over.

Unfortunately, these are not hard and fast rules. Just old timers’ tales.

Still, they are useful for understanding how markets work…and for keeping you from making a big mistake.

This gold market barely corrected 20% of its gains. Is that all there is? We don’t know. Doesn’t seem like enough. We didn’t feel tested at all; did you?

That was part of the reason we thought the economy was sliding into a Rip Van Winkle slumber. It would be a real test.

Imagine that China slows down. Imagine that Europe lurches from one crisis to another. Imagine that the US economy follows Japan down that long, slow, slumpy road. What do you have?

Falling prices for almost everything — including gold. And with falling prices for other assets, investors, savers, insurance companies, pension funds all put their money into US Treasury debt. This keeps rates low and it allows the US to fund its deficits almost indefinitely. The economy never recovers, but it doesn’t die either.

Bernanke and crew may want to do something dramatic and foolhardy. But they wouldn’t have to. As in Japan, they could just bide their time…

Pretty soon, people would come to think that the world economy had entered a more or less permanent phase of low growth and low inflation. And then, what would happen to the price of gold? It would fall. People buy the inert metal to protect themselves from very ert humans. But if the humans who run central banks and Treasury departments sit still, why hold gold?

The logic of the gold bull market is that the feds have done, and will do, stupid and disastrous things to the monetary system. Perhaps they will. But as long as they are able to finance large deficits painlessly, they have no reason to do so. Instead, they will take economist Richard Koo’s advice and use deficit financing to pay for fiscal stimulus projects. Infrastructure projects…transfer programs…tax the rich…bread and circuses for the poor — this could go on for a long time.

When speculators and savers realize that they need not hold gold to protect themselves from the feds, they will sell it. The price will fall — perhaps below $1,000. Then, we will have a real test.

If the economy is stuck in a low-inflation phase, why own gold?

If the feds do not have to print money, why would they?

If prices — in dollar terms — are stable or going down, why not just stick with dollars?

We can see the headlines now:

“Investors give up on gold.”

“Even gold-bugs are disappointed by the yellow metal.”

“No need for gold as world economy enters 7th year of stable prices.”

And then, you, dear reader. What will you do? The logic of the bull market will have disappeared. Will you give up on gold too?

In the near term, things are actually looking up for gold. In fact, since it didn’t fall as much as we expected…perhaps our Japan-like disinflationary slump has been delayed…or derailed?

Right now, the central banks are all itching to meddle. Bernanke’s “twist” program is a waste of time. It merely takes the Fed’s money and switches it from short-term US Treasury debt to longer-term Treasury debt. It is a very bad idea — leaving the Fed itself exposed to huge losses. But that’s another story. But it is unlikely to have any advantage for the economy. Mortgage rates are already the lowest in half a century. Pushing them down a little more isn’t going to make any difference.

Several members of Bernanke’s FOMC group are already calling for more forceful intervention — some form of QE III. If the economy deteriorates, there is bound to be more action from the Fed.

Meanwhile, the Europeans are “recapitalizing” their banks. So are the Chinese. The capital has to come from somewhere…or they have to invent it. The more new money they create, the less their old money is worth…and the more attractive gold becomes.

Bill Bonner
for The Daily Reckoning

The Daily Reckoning