Wednesday, September 29, 2010

Arguing with Mister Market

With the cost of money round the world at or near record lows, so that even the cost of borrowing for highly distressed borrowers is lower than the rates that the strongest countries borrowed at in the 1980s, distortion upon distortion exists in the financial markets.

The many of us who are greatly disappointed with the actions and inactions of the monetary and governmental authorities the past several years think we know better. Not only do we want to "argue" with Mr. Market (who may or may not be rigged beyond the acknowledged rigging of short-term interest rates), but many investors have a numerical target for, say, yield on muni bonds that they simply expect to be there. These muni investors are arguing with Mr. Market.

These people may be "dinosaurs" just as Japanese investors in the 1990s could not conceive of close to zero interest rates for an indefinite period.

In response to the money printing required to force rates near zero, many people have turned to gold as a hedge.

Then the public looks at gold at new nominal price highs and says, oh well, missed that move, the price is too high.


Yet John and Jane Q. Public probably have no idea that if they want to invest based on reversion to the mean of returns from financial instruments, if they go back 70 years, they will find that the calculated total return from stocks well exceeds the total return from gold, taxes and transaction costs excluded. So even though many people are increasingly comfortable with basically holding their stocks within their broad trading range of the past years, figuring they will rise one day, they are scared to step into the precious metals market, or if they have gotten in at much lower prices, they have not been buyers at higher prices.

Yet if one looks at the structure of large bull markets, which the precious metals market resembles (but of course may be topping out for all I know), gold and its junior partners may be at levels that will look cheap some years from now.

Assuming that gold prices are rising primarily due to free market activity, with governmental/central bank actions affecting the price only secondarily, then the normal psychology is for price breakouts to be tested. The Dow Jones 30 average (DJIA) first hit 800 in 1964. It was 778 in August 1982 when the Fed eased in light of a Mexican financial crisis. So stocks had an 18 year trading range in which P/E's shrank. Then stocks burst to new highs but retested the prior high of the trading range in 1984. But it proved to be morning in America, at least for stocks, and they more than doubled to 2700 in August 1987. From that level, when they fell by a third in that era's version of a flash crash, 1800 looked like a bargain, and then the real excitement began.

Arithmetically, recent numbers for the price of gold per ounce, which broke out past $1000 last year after falling into the $700s the prior year, are uncannily similar to that for the Dow, which was blocked for years around 1000, fell into the 700s in 1982, then burst out, never to drop under 1000 again once it quickly surpassed it a few months after the August 1982 bottom. Might gold's ultimate price peak be found within as long and strong an up-market as stocks experienced?

The many people who argued with Mister Stock Market in the 1980s, expecting the bear market to resurface, missed what was at first a rational bull market that had not yet gone to excess. My suspicion is that people who are arguing both with what I view as a rational precious metals bull market because they think prices are "too high" now are engaging in similar thinking as those who, scarred by a prolonged stock bear market, missed out on some excess returns available to buy-and-hold stock market investors who bought in after the break-out to new highs in 1983-85.

Of course, there are different ways to skin cats, financially speaking. People had plenty of ways to grow their capital in real terms in the 1980s and 1990s, or at least keep up with the rate of general price increases. Common stocks were not the only vehicle. Looking backwards from the future, we will likely see that even if gold meets or exceeds the goals of those investors who look to it to at least preserve real purchasing power, there will be other vehicles that will prove to have done the same thing.

For investors with little accumulated capital, such as young adults starting a career who cannot diversify, gold may be a sensible one-decision asset for all their eggs, for now. For retirees with more than a little capital, it's hard to see going all-in on gold or other similar assets.

The gold market has moved a great deal the past year, yet many gold stocks and gold ETFs show a remarkable apathy. I like this. It indicates that the public is not chasing investment-grade gold vehicles (though it may be chasing penny gold stocks).

Seasonally, not only is September a typically strong month for gold prices, but on average so is the rest of the calendar year. But in addition, there is the phenomenon that as with stocks in 1929, gold and oil 1979, stocks 1999, and in other cases, we have seen trends that have lasted a calendar decade reverse after the decade. (These include the deflationary 1930s giving way to the inflationary '40s and the booming 1960s yielding suddenly to the stagflationary '70s.)

No one knew in summer-fall 1979 that gold would skyrocket for the rest of the year and peak much higher in January 1980. No one knew at the end of a turbulent 1998 what would happen in 1999. So I want to sell gold only either when there is clear over-enthusiasm amongst the public or when my view of the fundamentals of fiat currency somehow change. I don't want to lose the upside potential of an unexpected massive further surge in gold prices.

Gold may falter in price for more than the typical correction that follows a large move, which it has had very recently. If that happens because central banks adopt prudent policies, great. Unfortunately, in my view, the U. S. authorities want more money printing. As the sole military and financial superpower, their printing press is more powerful than any other country's. Thus I want to hedge against the likely success of their policies by owning, one way or another, the one form of money the U. S. cannot create at will, and that Mr. Market has been favoring for some time, but not yet to excess.

To expect gold prices to enter a serious, sustained decline soon against the U. S. dollar is to argue both against Ben Bernanke and Mister Market.

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