Tuesday, April 5, 2011

Inflationary Adventures in Extremistan

The Fed's policies are in Nassim Taleb's "Extremistan" and may finally be leading us to a Pied Piper inflationary cliff.

In a recent post, I posited that people have gotten so used to the "temporary" emergency measure of (more or less) zero interest rates (ZIRP) that behind the seeming stability of this policy, one should prepare for extreme market moves. (This is a corollary of Hyman Minsky's thinking: false sustained stability tends to lead to later significant instability.) One such extreme move may have restarted, as g0ld busted out to yet another all-time high today. Gold rose 29% in price in 2010. It is now up 28% in price year on year as its weakest quarter, Q1, has now passed into history with no serious harm to the gold bull market having been done.

A correlation of the rate of gold price increases with the degree to which the Fed holds short-term interest rates too far below the rate of price inflation suggests a $2000/ounce price of gold in one year (the "Elfenbein rule" from Eddy Elfenbein of CrossingWallStreet.com).

Let's temper that for reasons such as reversion to the mean and project about $1750 per ounce.
Even under that scenario, there is lots and lots of room for gold stocks to break out and outperform bullion; and of course a 20% appreciation in gold would be quite a successful investment on its own right.

In a recent post, I noted that high-quality gold stocks had record earnings but non-record stock prices and thus were probably better investments than gold bullion itself. In line with my theme to expect extreme moves, several senior miners such as Barrick (ABX) and Goldcorp (GG) rose 5% today. Quite a move! (That's more than the total interest one would get over 3 years by lending money to the Treasury for that time period.) ABX and GG are now each within a fraction of point from their 2008 highs. Assuming gold trends higher, the trend for these two stocks is much higher.

The big financial institutions have not yet made much of a commitment to gold stocks and thus can be major sources of buying power; they will certainly start any program of investing in gold stocks with the dividend-paying major miners (a term that Joseph Heller would have loved). Further, my information is that at least until today, gold-oriented hedge funds have been actively shorting the stocks while owning bullion as part of a paired trade. That trade may have been put to bed - or in the grave - today.

My market optimism on this sector is further supported by the price action of the junior miners and the even more speculative gold explorers, who are generally not yet producers. These can be "played" via the ETFs GDXJ and GLDX. GDXJ is about 5% below its prior high of December 6, 2010 despite gold bullion now trading at a record. GLDX is within its trading range, as well. No special froth in either fund can be discerned from their price charts.

Premiums of various physical gold or gold/silver funds are also low, also something atypical for a bubble.

I believe the above demonstrates that there is no bubble in the gold market. (Of course, the absence of a bubble does not mean an asset is a good investment.)

An interesting set of low-risk investment strategies can be undertaken if one presumes that gold will continue to rise in price faster than money is losing purchasing power.

One could, for example, put most of one's money in cash or cash equivalents and put a minority of one's money in a precious metal vehicle, the stablest being gold bullion and the riskiest being a group of junior silver exploration and mining stocks. One possibility is that 80% of one's money could be in cash, losing purchasing power, while the other 20% could be directly invested in various precious metals vehicles and could rise enough to allow the total portfolio to rise, say, 6%, which may be the next-year's rate of price inflation. Most of the money is "safe"; the rest is not going to go to zero unless it is invested amazingly imprudently.

Of course, if one is young and has a career of earnings ahead, one may wish to roll the dice and put all one's savings into speculative metals vehicles, as the life-style downside should the entire investment be lost may not be all that great, whereas the upside is large and might for example quickly allow a house purchase that would otherwise be out of reach. Older retirees, on the other hand, may have no need to have their nest egg keep its purchasing power stable, at the other extreme, and may just ignore gold and silver entirely.

Gentle Ben thinks the rise in prices is transitory. I think this is more likely a case of sic transit gloria Ben. How long can he go on being wrong about almost everything almost all the time and still be invited back to 60 Minutes?

The weight of the evidence of basic economics and the message of the markets in late 2007 and throughout 2008 made me more and more scared that what was happening in sub-prime was unlikely to stay in sub-prime, and that due to the refusal of the authorities to take preventative action, that likelihood had an unacceptable chance of ending in a deflationary implosion. The opposite- an inflationary "boom" leading to a bust- may well be going on right now.

Central planning of large economies is a bad policy. When the central planners get it wrong, it compounds the problem. The blind mice in Washington may be forcing us into an inflationary explosion; today's price action may be one more bit of evidence that the unseen but inferred cord is a lit one.

Evasive action may indeed be called for.

Copyright (C) Long Lake LLC 2011

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