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The SEC
met in a roundtable this morning to discuss regulating the hedge
fund industry.
Investors must be demanding it.
Though I don't know any that would
throw their money at something without knowing what they're throwing
their money at. Personally, I'd like to keep it that way.
But the government insists on breeding
sheep, if you will. Investors shouldn't have to do their own
due diligence is their motto. Indeed, for their manipulations
and monetary schemes to work, they need participants willing to
believe they can make the maximum amount of money with a minimum
amount of work.
So I'm glad to see the street's top
cops producing results!
But how come all the other regulations
don't work? How many times are they gonna' rebuild that chinese
wall (Wall Street metaphor for regulatory division between research
and investment banking conflicts) for instance? How come unscrupulous
promotional activities spread to record levels of corruption during
the nineties, and on exchanges that were said to be well regulated?
How come indeed. How about because
regulation is not main the problem in the first place.
Nevertheless, industry insiders expect
the costs for hedge fund start ups to rise. So you see, the regulation
itself simply transfers the cost from the lazy investor to
the entrepreneur. But that's not even accurate, because in the long
run, it costs the investor even more, because the powerful can always
get around the rules.
Welcome to the new world order.
Enough of that. Nobody cares anyway,
right?
What the Hell are We Going to
Do with our Gold Stocks?
Gold prices are generally past their July 2002 peak, extending their
bull market trend, while gold stocks seem like they've gone nowhere
since then.
Meanwhile, bonds have made new highs
(in price), the Dow is engaging in its third countertrend rally
off last year's bottom in an attempt to reverse the bear market,
and the speculative Nasdaq market averages made higher intermediate
highs within a primary bear market (channel). The bulls say it's
because the weak dollar is going to stimulate the economy, but not
inflation.
Well, we all know most of them couldn't
tell inflation from a flying saucer.
That's precisely the problem of course.
That's why your gold stocks aren't going higher - because the process
of discovery is young.
 Your
local central banker knows this, which is one reason why the disinflation
noise is so loud these past few weeks, and particularly after last
week's FOMC statement prodding it along. They probably already know
the PPI/CPI figures this week are likely going to reflect March's
drop in energy prices, and other commodities.
In fact, that's the impetus behind
the new high in bond prices in my view - the bond market's buying
the disinflation propaganda hook, line, and sinker.
I bet core prices won't be down as
much as the headline number, but that the headline number will be
the bulls' focus - even as it's ignored in months when it rises.
Still, how do you reconcile, sensibly,
the combination of rapidly increasing money supplies / credit, a
falling dollar, rising commodity prices with the disinflation
(and lower yields) theme at the same time?
There is one way. There is the hope
that two years worth of Fed rate cuts will finally kick in to boost
corporate profits, and trigger a new bull market in equity valuations.
In other words, there's still hope
the inflation (easy money) will work, instead of break down, despite
the fact that it's breaking down right in front of our faces.
So gullible are the bulls that this
dollar devaluation is a deliberate policy maneuver, rather than
the product of a market saying the dollar's overvalued, that they
continue to price in the optimistic stock market outcomes.
The difference is enormous.
For, in the former case the Fed is
seen to have control over inflation / prices. And bond traders work
with the Fed rather than against it, at least so long as they believe
it anyway.
That means, essentially, when the
Fed implies interest rates can still be lowered, traders believe
it.
They do.
Every price rise over the past year
is explained in terms of a war premium, or it's isolated to energy
costs. The weak dollar is seen to be deliberated, and promises to
stimulate only the right prices.
The problem is the weak dollar is
not deliberated, and the Fed doesn't have half the control over
inflation the bond market thinks it does.
Yet it's that very delusion - that
there's disinflation or that inflation is under control - which
we'd argue has fueled Wall Street's several comeback attempts over
the past 10 months, by pressuring bond yields.
Correlate the timing of the lows
in Bond yields (above) to the Dow's comeback attempts in the same
period, and you'll understand why Wall Street's bear market has
stalled. The lows in yield precede every rally, except the last
low came during the Dow's recent rally.
 The
stock and bond markets have generally squared off since last summer.
When stock prices rise, bond yields do, and when stock prices fall,
bond yields have.
We've noted this relationship several
times in the past, but expected the dollar's bear market to break
it in favor of the bears - both stock and bond.
Instead, perversely, the dollar's
bear market combined with the Fed's disinflation propaganda seems
to have kept optimism for earnings high, while the outlook for yields
low. The result has been a decoupling of that relationship in the
bulls' favor.
In other words, rising stock prices
didn't inspire rising yields, like they normally have - since 1998
anyway. Indeed, while analysts up their earnings outlooks for Wall
Street for the remainder of the year, the press was simultaneously
reporting on the prospects for deflation.
So as bond yields fall, the accompanying
uptick in earnings outlooks for the rest of the year makes equities
look as cheap (relative to bond yields) as they've been in more
than 10 years.
So if you're looking for reasons
as to why your gold shares haven't performed over the past year
despite feeling increasingly right in your outlook, look no further
than the fact that bond traders obviously still don't believe there's
inflation, or they don't believe it'll erode their income, or they
are convinced the right argument is deflation.
Because if that's the case, why not
buy other stocks? They're cheap indeed, provided bond yields remain
low, and inflation is really under control like the Fed says it
is.
Of course, bond yields aren't sustainable
at these 45 year lows unless there really is going to be deflation.
But if there was going to be deflation,
consider this - the Dow may be cheap in relation to yields, but
it would be expensive relative to earnings.
My point here is there's no deflation
priced into the stock market, the dollar, the commodity markets,
or much of anywhere for that matter except for the Treasury market,
which is trading more like a corporate bond than a government bond
anyway.
Unfortunately for the Fed, dollar
weakness translates into an environment where the prices that benefit
from the inflation are commodity prices at first, then employment
costs, then pricing power returns in many industries.
Profits will undoubtedly rise, but
they'll increasingly be recognized as nominal.
The sectors most likely to benefit
from an increase in earnings from dollar devaluation are the commodity
sectors, because they are less overvalued than the stocks of companies
in the export business, and also because commodity prices rise first
in such an environment.
It's really simple. To think that
dollar devaluation could result in a benign healing of the current
account deficit and stimulate technology earnings over commodity
earnings is a delusion that I think Wall Street's bulls are going
to have to face the truth on soon.
So that's where gold share investors
are left. The inflation, they
know is there. And the evidence has been piling up. But the critical
moment - or the point of recognition if you will - has been evasive.
Moreover, if it all somehow resulted in a new bull market
for the Dow, strong enough to turn the dollar back up, that moment
could be pushed further away perhaps. That's what I estimate is
holding back the sector.
Here's the thing though.
As more people realize the inflation
is endless, gold prices will get stronger and stronger, as they've
been for the past few years, and for the past few weeks in fact.
And as they get stronger, it means that participants are devaluing
the dollar, or that their dollar outlook is increasingly bearish,
which means there's too many dollars. It's that simple. Even the
Kudlowians know that rising gold prices mean there's inflation.
What they probably don't understand
is that it really means there's an increasing perception that
the inflation is endless, and confidence in the economy/currency
is dropping.
We know that chances are the PPI
number is going to be weak this week. But the question is whether
people will buy it, or not. I'd like to think the markets will place
more weight on real time developments than those figures in determining
the inflation outlook. But I fear what might happen is that the
figures will boost the Fed's disinflation theme, depress gold prices,
and boost the dollar.
In other words, I fear the market
will keep believing the Fed's data. Yet we've been heartened by
the fact that gold prices have been strong all week long amid ongoing
dollar weakness. So far, at least by those markets, participants
aren't believing the Fed's claims. We'll see if that changes by
Friday I suspect.
 The
key to the gold share market then, at this point, is whether the
new highs in bond prices this week stimulate further gold strength
and dollar weakness, or whether they can break the Dow out of this
10 month range, and strengthen the dollar.
One way or another, the bond is setting
itself up for a big fall. If the Dow breaks out, for instance, and
markets believe that the resulting rise in yields is the result
of rising stock values, it's possible that the gold sector would
suffer.
But to take that bet, I think you'd
have to believe one of the following:
- there's no inflation at the source
of it all
- earnings will come back so strong
that a rise equity values could tolerate a rise in yield
On the other hand, if gold shares
rose on a break out in the Dow, it would mean to us that the gold
market doesn't believe the Dow's move sustainable.
The higher high in the Nasdaq last
week has got some gold sector investors concerned that the broader
market averages might follow. But so far the idea hasn't attracted
many suitors. Even some of the old bulls seem to distrust the current
move on account that the leadership is speculative.
 Personally,
I don't think the Dow will break out, and if it does by some chance,
I doubt the move could attract enough believers, or come with the
earnings, to sustain it.
When we look at the charts, what
we see is that the dollar is in a solid downtrend; gold and silver
prices continue to be under accumulation and are currently poised
to break out themselves; and that all stocks - gold stocks included
- have pretty much gone nowhere since last June/July.
But when we look at a chart of the
Dow, and a chart of the AMEX Gold bugs index, we note that the Dow
is still confined to a bear market sequence and that gold stocks
are still controlled by a bullish sequence - see charts below.
Moreover, while the nature of the
Dow pattern (June to May) appears rather neutral overall, the gold
stock charts reflect a degree of accumulation - note the ascending
triangle in the chart of the HUI below.
 Still,
investors have grown impatient. Understandably so, since the evidence
of inflation is quite conspicuous.
But I think it's not quite correct
to criticize the lack of leadership by gold shares in the gold price
move to $390 earlier this year.
I think it's important to recognize
that while the AMEX gold bugs index reversed a primary bear market
sequence in June 2002, gold prices didn't reveal a primary bullish
sequence until December.
In other words, the gold price spike
was catch up. Now the question
is whether it will continue.
The bears tested bullish support
for both gold and gold shares in March. It held. It's correct I
think to now expect gold shares to lead again as the outlook
for gold prices increasingly brightens.
 And
they have been outperforming gold prices to a degree.
So our outlook is this:
The Dow may or may not break out,
but gold shares will, and they'll break out along with gold and
silver prices.
If the Dow does break out in such
an environment, its back will break on the first hint of a serious
bond market slide (or higher interest rates).
Our six to twelve month targets then
are as follows:
- HUI = 200 to 230
- DJIA = 5000 to 7000
- Gold = $425 to $475
- Silver = $6 to $7
- Dollar/Yen = 100 to 105
- Dollar Index = 85 to 90
Can't Have Deflation Amid Weak
Currency, Sorry...
I think if you're bullish on gold and expect deflation at the same
time, what it means is you're afraid of being right.
If you're bullish on gold, you have
to be bearish on the dollar (unless you're not that bullish in the
first place). If you expect deflation, however, what you expect
is a contracting stock of money to result in an increasing value
for the currency, rather than for goods or services.
The prices for goods and services,
as you know, are impacted by changes in the value of the currency
as well as changes in demand and supply.
Consider it this way. There are two
markets operating simultaneously. One where the demand and supply
for a good or service interact to produce value for it, and another
where the demand and supply for money (or currency) interact to
produce value for it. Together they express as price.
They aren't wholly independent of
each other, but can be theoretically considered that way. Moreover,
it's just as correct to say one dollar is worth a cheap beer, as
it is to say a cheap beer costs one dollar. But today, we've been
trained to ignore the former proposition. Anyway, the point is the
dollar isn't worth a cheap beer!
The only time an increase in money
supply doesn't result in an immediate devaluation of the currency
is when participants are convinced demand for money is growing as
fast as its supply.
In any case, how do you have deflation
if you accept, as we do, that the currency is overvalued?
1) either you're convinced that money
supply will somehow contract, or
2) you mean deflation in some sectors and inflation in others.
Number 1 is easy. It can't contract.
Good luck. It never has, and if they run out of ideas on how to
increase money supply, no problemo, we've can send 'em some. The
only string the Fed's pushing on is the one tied to your leg, and
they're pulling not pushing it.
I've asked readers to go out and
find us a period since FDR abandoned the (phony) gold standard in
1934 where the stock of money contracted without briskly recovering.
I've never heard back from anyone, and I couldn't find the evidence
myself. I wonder, is there a connection between that and the fact
that the closest we've come to deflation since 1929-1933 (when the
dollar was fixed to gold) was in 1982 after the dollar fell so far
and wide it became, well, undervalued?
Yup. You bet there is.
So let's rule out number 1 once and
for all. The real challenge is not how to increase money supply,
it's how to restrict inflation.
As for number 2, we agree with it.
The main problem with inflation is
that it produces malinvestments, which means the economy over produces
one thing or another, and underproduces others- which in turn means
it's unsustainable, and a host of other things as a consequence.
So it's conceivable that some industries,
like cars, technology, and even housing, have been overproduced
relative to some concept of real demand. In those industries, prices
may come down even if inflation (monetary) remains rampant.
Let's put it this way - there is
always inflation. The problem analysts have is knowing how it impacts
value. In other words, understanding
the difference between what's real and what isn't (real = market
driven, rather than inflation induced).
Yet understanding this impact is
where we must begin in our assessment of the sectors that inflation
has undervalued and those that it has overvalued, which will help
in determining which prices will fall and which are going to rise,
as a result.
Yes, that's right, prices can fall
during an inflation if the inflation creates the illusion of value
where it isn't. It simply means while one thing is gaining in value,
something else is falling in value. Those goods that gain in value
as a result of inflation will become overproduced. Those goods that
lose value become underproduced. Of course, this assumes the heretic
idea that money is not neutral.
However, as previously proposed,
if everyone perceived the inflation to begin with, "any" increase
in the money supply would immediately manifest in all prices. So
none of the malinvestment would happen in the first place, theoretically.
Indeed, the process assumes that
inflation isn't perceived... that it is hidden! They hide it by
persuading you it's something else, like liquidity, or elastic money,
rather than inflation.
For the past two decades, profuse
monetary inflation has overvalued paper assets at the expense of
commodities, while simultaneously fueling present and future demand
for those 'cheap' commodities. The result has been an economy
that has structured itself around the production of overvalued paper.
But now that the inflation no longer
can sustain increases in the value of that paper (or equity) and
expectations for growing real profits, a revaluation has begun,
and consequently, scarcities have been revealed in some of the commodities,
particularly the ones that are on the Fed's blacklist for rising.
This process results in the discovery
of inflation (that it exists, and that it explains most growth),
and a healing of the economy.
That indeed is what the gold bull
market is about.
The markets are efficient, but not
as efficient as they could be if they were in reality as perfect
as they were in theory. I mean perfect in the sense of 'rational
expectations' theory, rather than simply 'perfect competition.'
But one thing I'm certain of is this:
if you expect deflation (in terms of the dollar), you shouldn't
be bullish on gold prices. If the supply of money per chance were
to shrink, but so did the demand for dollars, the dollar would still
fall, and you'd be right to be bullish on gold.
Deflation means the impact of a shrinking
stock of money on prices. Remember our example of two markets? That
means that by deflation, you mean this impact affects an increase
in the value of the currency such that the prices of goods/services
generally fall.
So unless you are prepared to accept
a rising dollar value in your outlook, forget about the idea of
deflation. And if you are able to develop the case for a rising
dollar value, forget about gold.
The only reason to buy gold is if
you're bearish on the dollar's value, and perceive the policy of
inflation to go on indefinitely until it results in a crack up boom,
which means precisely that the dollar falls in value against everything.
Accordingly, the case for gold is strong.
It's so strong in fact, that it's
a wonder the government hasn't discussed investing America's social
security fund in gold stocks.
Edmond J. Bugos
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