Arctic Goldfinger

Magical thinking seems to be a basic human trait. There is some innate optimism that makes us think that we can “defy the odds.” There is no better tribute to the power of magical thinking than Las Vegas.

I used to be quite a gambler myself. For some reason I thought that some Higher Power would make the dice hop down the table and come out my way. I didn’t just think that I might win. I EXPECTED to win. Sometimes I did and sometimes I didn’t. But my intellectual understanding that the odds were against me never shook the feeling that I was going to get lucky.

I eventually learned, however, that my wishes and desires are not a factor in the way things turn out. I still like to gamble, but now know that I need to be “lucky” and (a) it won’t happen more often than it will, and (b) whether it happens or not has nothing to do with me. It’s simply part of the laws of probability that sequences favorable to the player will occur in the short run, if you are in the right place at the right time. But all the rabbits feet in the world won’t make that happen if it’s not your day.

I say all of this to introduce a sad reality — that a bull market in gold is the harbinger of economic problems. To put it another way, if gold goes to $2500 an ounce it will do so in the context of a much altered and very troubled world. It will probably mean that people’s wealth is being rapidly eroded by powerful inflationary forces and that the poor and those on fixed incomes will (as usual) suffer the worst. It might signal a collapse of the international monetary system and a worldwide depression. Whatever it is, it won’t be pretty.

I have decided, however, that I won’t feel guilty for, as they would say in craps, “betting the don’t.” I am not rooting for all these troubles. I am just investing in accordance with a reality that I did not create.

It is possible, of course, that there could be a positive economic turn of events and that gold would languish or even crash. But that would entail a flushing out of the massive debt in our economy. It would require money to become valuable again and that, in turn, would require money to become “tight.” Many many people would lose their homes and businesses and the country would slide into a major recession or even depression until the system repairs itself. Those are simply the wages of economic sin. Debt must either be defaulted upon or paid. There is no other option.

In my opinion that scenario is highly unlikely. There is no one with the political will to pay that sort of price. Money printing and deficit spending are much easier than budget cutting and monetary tightening. Beyond that, Fed Chairman Bernanke, a student of the Great Depression, will not want to be known as the man responsible for another one.

The likely outcome will probably be the usual: inflation. Rather than suffer defaults on the mountain of debt it will just get paid off with cheaper dollars. Will there be a repeat of the hyperinflation of the 1920’s in Germany? Probably not. Just a long sickening slide into economic mediocrity with people having their pockets picked by inflation day after day and week after week.

As for gold, it will, as always, be the ultimate money. Gold may fluctuate in price when reckoned in terms of printed money, but it will never become valueless.

You don’t have to be a financial genius to spot the bullish trend in the gold market. It jumps off the page when you look at any weekly or monthly price chart. For six years the gold price has risen in the classic bull market pattern — a series of higher highs and higher lows moving diagonally in waves toward the upper right hand corner of the page.

But a chart only tells you about the past. The big question is whether gold is going to continue to rise in the future. I believe that it will and I base my opinion, in part, on my view that the recent bull market in gold, since its beginning, has been a “realizing market.” To explain what I mean, I need to delve into bull market anatomy.

The credit for my terminology goes to Bill Gary, the President of Commodity Information Systems, a publisher of commodity price charts. He divides bull markets into two major categories: “anticipatory” bull markets and “realizing” bull markets. The difference between the two is striking.

An “anticipatory” bull market is fueled by some specific ongoing event that, in the mind of the bulls, will soon lead to a significant and identifiable tightening of supply. And less supply, of course, all things being equal, means higher prices. Anticipatory bull market are very obvious, very exciting and can be extremely short lived.

The classic example is a “freeze” bull market in orange juice futures. It seems to happen almost every Winter. A huge arctic high pressure system starts to sweep South from the Canadian plains. The instant that is recognized the O.J. futures start to twitch. As the cold front moves toward Florida the futures price of O.J. begins to rise.

What is happening is that speculators are betting that the cold front will reach Florida and decimate the orange juice crop. That’s not very nice of them, I suppose, but business is business. The sellers (the people on the other side of the trade) are betting that the crop will survive.

The sellers usually win. The cold front either peters out or simply isn’t strong enough to affect the crop in the face of defensive measures from the growers such as smudge pots and spraying the fruit with water. (Don’t ask me why that works, but it does).

The whole drama is enacted from start to finish over a matter of days, but you can see how the bull market is “anticipatory.” The orange crop is just fine when the bull market begins, but traders are anticipating a supply disruption. Also, there tends to be a lot of news coverage and market excitement in an anticipatory market. For O.J. traders, The Weather Channel, at least for a while, becomes more interesting than CNBC. (In fact, in my opinion it is almost always more interesting, and certainly more informative, than CNBC).

All “weather markets” are anticipatory and they are more typically played out over a matter of months. “Drought markets” in grains are good examples of anticipatory bull markets, with futures brokers trying to rev up market excitement with talk of “beans in the teens.” But the result is usually the same as with the O.J. — the crop survives and the sellers win.

“Realizing bull markets” are a whole different breed. Rather than being fueled by information, they seem to just happen. And, because there is a lack of hard information, there is skepticism and doubt the whole way up.

The current bull market in crude oil happens to be a pretty good example. There are lots of theories as to why the market has been rising, but there are plenty of doubters ready and willing to dismiss each theory. Is it because of “peak oil” (the theory that the world’s oil supply is running out)? Is it tension in the Middle East? Is OPEC keeping oil off the market? Who knows? But there have been skeptics every inch of the way up from fifty dollars a barrel to almost a hundred.

This is called a “realizing” bull market because the market realizes that there is tightness of supply only after the fact. Since the market move never seems to be explained it is repeatedly questioned. Every downturn is proclaimed to be the end of the bull market. Of course the market immediately starts heading right back up and makes new highs.

One of the characteristics of a realizing bull market is that it has “legs.” It goes much farther than anyone (other than the hardest core of the bulls) ever considered imaginable. Who ever thought that crude oil in 2007 would pass ninety dollars a barrel? The market climbs the proverbial “wall of worry” that characterizes bull markets. (Bear markets “flow down a river of hope”).

In my opinion the bull market in gold is a classic realizing market. There are lots of theories to explain it, but every one has its doubters. Maybe it is slowing production from mines. Maybe it’s the falling dollar. Maybe it’s less Central Bank selling. Maybe it’s stealthy Central Bank buying. Maybe it is the price of oil. Take your pick. I certainly don’t know.

One thing for sure is that there is not rampant bullishness among the public. Not even close. A twenty-eight year high in the gold price barely made the news. The Main Street investor simply doesn’t have gold on her or his radar screen. Every correction is proclaimed to be the end of the bull market. In contrast, in an anticipatory bull market every correction is called a “buying opportunity.”

My analysis of bull markets is hardly the only one available. It is common to describe bull markets as moving in “stages” with the early ones being quiet and the later ones frenetically speculative. I simply view that as a realizing market becoming an anticipatory market with the public moving in and the pundits declaiming about some imminent market scenario will drive prices to the moon.

That explains my belief that the time to get out is when the public starts getting in. That is why, in my “Gold Market Advice for Today” on this site, I have specific touchstones for the time to leave. Having gold show up on the cover of Time Magazine is my favorite. At that point everyone will be talking about the impending collapse of the international monetary system, everyone will be recommending gold, and the end of the bull market will then be in sight since the end of the world, in general, tends not to happen.

In the distant past, former Fed Chairman Alan Greenspan was a rabid “gold bug.” His article “Gold and Economic Freedom,” written in 1967, is still a classic defense of the role of gold in the monetary world. The full text can be accessed from my Blogroll using the link entitled “Greenspan on Gold.” I strongly suggest that you read it right now. It was a masterpiece when it was written and it is a masterpiece today.

Now fast forward to 2007. Alan Greenspan’s memoir, “The Age of Turbulence,” is a New York Times best seller and talks about gold in several different chapters. Greenspan, to his credit, is openly nostalgic about the glorious era of the gold standard when inflation was virtually nonexistent.

But he explains to us that modern society has made a bargain with the Devil which has made inflation virtually inevitable. He lays it on the line. We are unwilling to pay for entitlement programs such as Social Security and Medicare by taxing ourselves. Instead, we run persistent deficits. Monetary inflation is the unavoidable result of printing the money necessary to pay for more things than we are willing to tax ourselves for.

He predicts, therefore, that we are facing a major inflation problem going into the future and that the Fed will have no choice but to fight inflation with its major weapon — higher interest rates. And not just higher nominal interest rates, but higher REAL interest rates. That is, interest rates that exceed the rate of inflation. (Given the B.S. built into the governments CPI numbers, the interest rate right now would have to be over 10% to meet that objective).

So is gold out of the picture? Here is what the Maestro says on page 481: “For the most part, the American people have tolerated the inflation bias as an acceptable cost of the modern welfare state. There is no support for the gold standard today, and I see no likelihood of its return.”

A few pages later (page 491) he reflects on the question of whether stable prices will ever be possible. He says: “Monetary policy can simulate the gold standard’s stable prices. Episodes of higher interest rates will be required. But the Volcker Fed demonstrated that it can be done.”

Ah! The Volcker Fed. For those of you who are too young to remember, Fed Chairman Paul Volcker, during the Jimmy Carter Presidency, was appointed in the midst of the last great gold bull market and at a time when inflation (as honestly reported) had clearly gotten out of hand. Volcker boosted interest rates into the stratosphere and had Federal T-Bonds yielding double digit interest rates. This boost in real interest rates brought inflation under control by pushing the economy into a major recession.

Greenspan has laid out the challenge very accurately. If you want the essential characteristic of gold, that is, an absence of inflation, the Fed has to be prepared to substantially raise interest rates and create a real return on cash as opposed to the inflationary death by inches that we are experiencing today.

So it all boils down to whether Bennie and Ink Jets have the onions to raise interest rates to much higher levels. It is important to note, however they have to deal with issues that Volcker did not. We now have a nine trillion dollar national debt and massive deficit spending. Also, at the moment, we have a financial system that is in a shambles thanks to the consequences of the ongoing real estate bubble.

The fundamental question for the gold investor, therefore, is whether Bernanke is likely to pull a Volcker. In my opinion, that is not likely to happen (if at all) until gold has gone much higher than it is right now. In the meantime, I appreciate the Maestro’s kind words about gold.

As for the gold standard, he may be right that it will never come back. There may be some other solution out there to the current worldwide economic mess. In the meantime, however, gold is going to appreciate in value while everything sorts itself out.