The Stock Market - relative strength comparisons

1.Fundamental outlook

'Worse than expected'

There can be little doubt that current economic fundamentals are extraordinarily bad – the new stock phrase that accompanies almost every economic data release lately is 'worse than expected' – and this happens with expectations already lowered considerably. A good way of following the evolution of expectations are WS estimates for S&P 500 earnings in 2009. These have gone from $98,-/ share about a year ago to $42/share now. There have been numerous revisions along the way, and economists are similarly revising their guesses as to economic data about to be released.

It is generally agreed however, that knowledge of current economic fundamentals is not necessarily useful information with regards to what the stock market is about to do. The theory goes, not unreasonably, that the market tends to discount fundamentals ahead of their manifestation. However, as i have previously pointed out, this has generally not been true over the past decade or so. The stock market has most of the time acted as a coincident, and at times even lagging indicator, at least relative to official economic data.

Nevertheless, this does not change the fact that current fundamentals are a poor guide to market action over, say, the next four weeks for instance. There could be a rally in spite of a continuing deterioration in fundamentals, pinned on nothing but hope (the 'it's so bad it can only get better' thesis of investing), or pinned on a more reasoned approach that is based on the general idea that stocks are not merely a claim on earnings streams in the relatively near future – rather they are a claim on earnings streams into the far future.

Still, it would be good to have a crystal ball that informs us of future fundamentals. Can we make an educated guess? A large percentage of mainstream economists routinely disappoints in the economic forecasting department. One can certainly not rely on their timing, and neither can one rely on their general forecasting abilities. How many economists did in fact forecast the bust? Given that they have obviously a tendency to have too rosy an outlook even in the face of one of the worst contractions of the post WW2 era (thus the never-ending 'worse then expected' moments), why should one believe their estimates of when a bottom is likely?

A review of the known facts is in order.

1.we are in a secular bear market period, which will be marked by a secular contraction in p/e ratios, from the over-valuation seen in 2000 to an as-of-yet undetermined level of undervaluation.

2.Such a bear market is accompanied by recurring economic busts of increasing severity and duration – busts that are a mirror image of the preceding boom.

3.The current bust has a unique feature - the banking system appears on the brink of insolvency after having inflated credit willy-nilly for several decades (this is no exaggeration as the US total credit market debt / GDP ratio shows).

4.The authorities – fiscal and monetary, know only one recipe to counter the bust – inflate, inflate and inflate some more (in a combination of using the printing press and blatant Keynesian deficit spending; both methods have been thoroughly discredited throughout history in practice as well as theory, but are resorted to as a matter of course anyway).

If we only consider the above, it is clear that the current bust is of a different order of magnitude than its predecessors. While it was also precipitated by relatively tight (relative to the period preceding it) monetary policy for a short while (2004-2006) , its major feature is the sudden incapacitation of the banking system – the very system at the heart of the practical implementation of the inflationary policy of the modern day industrialized welfare/warfare democracies.

It is important to note that the final inflationary boom – the real estate mania, respectively mortgage credit bubble, already saw the stock market decline sharply in real terms, even during the cyclical, nominal bull market phase.
In other words, the only thing that drove the rally from the 2002/3 lows in stocks was the inflation of money and credit. This becomes evident indirectly by the expansion of margin credit and the enormous leverage taken on by hedge funds and investment banks during the period.

It was a levitation on hot air - based on the false confidence that everyone in the chain of credit that was extended during those years would be able to pay.
The plunging Dow/gold ratio indicated though that it was an entirely illusory boom.
Given how the authorities have reacted thus far to the bust – the central question then becomes 'will they be able to create another inflationary boom?' In other words, can reality be masked again by a new illusion of wealth based on the inflation of money and credit?

This seems a tall order – since there is a limiting factor in the real world that doesn't lend itself to eternal exploitation – the pool of real funding. It matters not how many pieces of paper or electronic chits the Fed prints up in its balance sheet expansion – the amount of real resources available to the economy can not be changed by that.

The reality of the banking sector's balance sheet implosion is currently partly camouflaged via the Fed's interventions, but it can likewise not be winked out of existence.
What the banks now lack is capital – as their existing capital has been eaten away by too many securities turning worthless, and too many debtors defaulting. The problem is that everybody else lacks capital too, or owns capital for which there is currently no use and that can not be profitably employed in its current incarnation (a number of car factories come to mind, for example).

We can conclude that the bust will be intense, and investment strategies will have to be adapted accordingly.

The time of 'buy and hold' has been over for ten years already, even though a surprising number of analysts still seems to cling to this mantra of the bull market. Perhaps they should have specified 'buy and hold t-bills', since those have outperformed the stock market by nearly a cumulative 40% over the past decade?
Likewise, it appears the 'money multiplier' has degraded into a 'money divider' as Bob Hoye has recently put it.

2. Technical conditions

In terms of the stock market's technical condition, it is surprisingly poor. Why 'surprisingly'? There are quite a few historical examples of a market crash in the fall, both in the 20th and 19th century. One common feature of all those crashes has been a subsequent rebound that went hand in hand with a lessening of credit concerns and as a rule managed to retrace at least 50% of the preceding crash wave. A notable exception to the rule was the 1987 crash that happened in the broader context of a long secular bull market – in this case, the rebound erased over 100% of the crash wave before running into temporary trouble.
The point is, it is unusual to see the market as weak as it has been so far in January right after an autumn crash.


The S&P 500 Index with Elliott wave labeling. Wave 4 is likely still in progress. click on chart for larger image

It is possible, even likely, that the expected rebound will still happen with a delay. However, given the unusual action up to this point, one must be prepared for the alternative as well – a further wave of selling. As previously discussed, the market lends itself to a relatively obvious Elliott wave count since the October 2007 high. The corrective action since the 'wave 3' low has been a bit more difficult to interpret, which is a common feature of corrective waves, as there are a great many variations possible.
From this standpoint, the main question is 'are we still in corrective wave 4' or 'has wave 5 down already begun'.

One of the arguments in favor of a rebound is the fact that a number of market participants are reportedly simply waiting for the current horrible earnings season to be over before committing new capital. The earnings season is regarded as being chock-full of the same event risk that is currently dogging economic data releases – the 'worse then expected' syndrome.

Ironically, an argument can be made that the market is actually not 'oversold' , as Carl Swenlin shows here in this 'chart spotlite' at decisionpoint.

From experience though it can be stated that the shorter term the time frame considered, the more difficult it is to forecast the likely outcome. If acting in favor of one outcome, one should always prepare a plan of action for the opposite outcome.

Assuming that the rebound will resume, the question of which sectors are most interesting comes to the fore. Below are a number of 'relative strength' charts. They show how different market sectors have performed relative to the S&P 500 over the past year – whereby their performance since the November low is what interests us here.


Airlines have outperformed the rest of the market since the peak in oil prices. Note however that this streak seems potentially endangered now, which may be a hint that energy prices are about to rebound. Option traders are optimistic on airlines. put/call open interest across the sector is the lowest in the past year, and short interest in the group's most prominent component stocks has declined sharply. click on chart for larger image


Banks have once again strongly underperformed the market of late. As can be seen here, the BKX-SPX ratio chart broke the neckline of a head-and-shoulders formation, but may already have met the target range, and is now deeply oversold. Near term, we would avoid this group from both the short and long side. There's no need to try to bottom fish given the industry's sorry state and the risk of a snap-back rally is too great to make it an enticing target for shorting. This sector is best left to those who want to play hero. Interestingly, the sector-wide p/c open interest ratio of 0,87 is actually very low compared to the readings over the past year.
Note: as the market cap weighting of financial stocks declines, their influence on the market-at-large declines commensurately. click on chart for larger image



The biotechnology index has outperformed the market since last spring. The sector-wide put/call open interest at 0,62 is fairly high compared to readings over the past year, which is to say, option traders are rather pessimistic on this group now. Good relative performance coupled with pessimism is a good omen for this sector. click on chart for larger image


The Broker Dealer Index has made no headway relative to the market since the November low, and remains in its longer term down-sloping channel. Short interest remains high, but option traders are curiously optimistic on the group. We see no reason to engage with any financial stocks, given that their outlook remains bleak. Financials should be watched for signs of getting overbought, at which point they will likely continue to provide shorting opportunities for nimble traders. click on chart for larger image


There's nothing remarkable about the performance of the Chemicals Index either, which is essentially also going nowhere relative to the S&P, following a streak of under-performance since the fall. As a cyclical sector it suffers from the sharp deterioration in the economy. click on chart for larger image




Due to containing a large weighting of Wal-Mart (WMT), the MS consumer index CMR has outperformed the broader market. The discretionary consumer ETF XLY may be the better gauge in this case – it has flat-lined relative to the broader market, which is to say, it has performed just as badly. In short, there are neither fundamental nor technical reasons at this time favoring this sector. click on charts for larger images



Disk Drive stocks have begun to outperform since the November low. It remains to be seen if this can be kept up due to the fundamental challenges faced by this industry. Still, storage is perhaps one of the better sub-sectors in the tech hardware world. click on chart for larger image


There is always a lot of worry about the pipelines of the large pharmaceutical firms, and the sector has for a long time been a downside leader (it was one of the first groups to break below its 2002 lows). However, strong balance sheets, high dividend yields and an intriguing streak of outperformance in recent months make this sector interesting. click on chart for larger image


Computer Hardware shows strong relative performance since the November low, mostly due to component stocks like IBM and HPQ. It remains to be seen whether this can be kept up – option traders are optimistic, and there are a number of fundamental reasons to remain wary.
click on chart for larger image



Internet stocks are helped by GOOG's less than horrible recent earnings report. There is however nothing especially exciting here. click on chart for larger image




The upcoming period of seasonal strength in energy could help both the XOI and OSX. XOI currently looks better on a relative strength basis, but the OSX is traditionally lagging, and usually has a higher beta, so it could play catch-up. click on charts for larger images


RTH's relative strength is helped by Wal-Mart (WMT). For obvious reasons, retail stocks should probably be avoided. The best thing that can be said for them is that most are technically oversold by now. click on chart for larger image


Networking stocks have been going nowhere in particular relative strength-wise in a wide channel. click on chart for larger image


The Semiconductor sector has recently strengthened as well, but the group remains suspect for fundamental reasons. click on chart for larger image


The relative strength chart of the telecommunication group is intriguing, as it is attempting a break-out. click on chart for larger image

The point of this exercise is basically, 'if you have to be long something, choose whatever shows good relative strength' . Two of the biggest reasons why I personally have become a bit more constructive vis-a-vis the stock market in the near term can be found below (please note, i remain medium to long term bearish):


The US dollar index appears to have built a bearish flag – a decline in the dollar would likely go hand in hand with rising stock prices. click on chart for larger image


The safe haven buying that supported the huge rally in T-bonds has subsided. The initial correction target has been met, so a rebound is increasingly likely. However, the bearish influence the bond market had on stocks has clearly lessened (currently, lower interest rates on long term government bonds are a bearish, not a bullish sign for stocks). click on chart for larger image

3. Gold and gold stocks

I'm looking at gold and gold stocks in a separate section because the gold stocks are currently the one market sector with the best fundamental and technical outlook.

Here is why:


Gold weekly, 3 years. this chart looks constructive click on chart for larger image


On the daily chart we can see that a big test lies just ahead for gold - the resistance in the 920-930 area that has stopped the previous rally attempt. It seems likely that this won't be overcome on the first attempt. Breaching this resistance would be a a very positive sign. click on chart for larger image


Gold keeps streaking higher against the S&P index. At the moment it is attempting a new break-out in relative strength terms click on chart for larger image


Gold has risen enormously relative to crude oil. Energy is a major input cost for gold miners, so this is a boon for their profit margins. Interestingly, Wall Street analysts are generally very lukewarm toward gold stocks. click on chart for larger image


Since the low was put in, the HUI has risen sharply vs. the SPX, but the relative strength chart is now running into short term resistance.

To reiterate something I have mentioned before: the gold sector will probably be the only major market sector to deliver earnings growth in coming quarters. In spite of this, it is strangely unloved by many in the Wall Street analyst community.
Let me name a few examples.

Newmont Mining (NEM) for instance currently sports 4 'strong buy', one 'buy' and 8 'hold' ratings ('hold' is the Wall Street euphemism for 'you should have sold it yesterday'). Put/Call open interest on the stock has soared in the past few months, from roughly 0,60 to about 1 now.

Barrick Gold (ABX) has 6 'strong buy', 1 'buy' and 7 'hold' ratings; put/call OI on the stock has also soared lately.

Goldfields (GFI) has 1 'strong buy', 2 'hold', and 1 'sell' rating. Note in this context that the price of gold in South African Rand is at a new all time high (!) , while GFI trades about 65% below its former all time high. p/c OI on the stock has doubled of late.

Harmony Gold (HMY) has 1 'strong buy', 1 'hold' and 1 'strong sell' rating. I'm not sure who dispensed the 'strong sell', but the company's balance sheet is stronger than it has been in years, it has 5 growth projects in the pipeline, and the fattest margins in at least 5-6 years.

You get the drift – Wall Street isn't exactly brimming with love for gold stocks. This is of course excellent news for anyone holding them, as it increases the chance for future upgrades.


Gold in South African Rand. This is a nice, steady bull market progression. The profit margins of South Africa's gold mines are soaring along with it.

Some thoughts on the recent backwardation in gold

Definitions

Let me start with a definition of the term 'backwardation' for readers that are not familiar with it.
A commodity like e.g. crude oil that trades in a futures market, has many different contracts trading concurrently, for different delivery dates in the future. Normally, the contracts for later delivery will trade at higher price than those for earlier delivery. This 'normal' state of affairs is known as 'contango'.
The reason why contracts for later delivery are normally higher priced is that they must reflect two cost factors that are a function of time.
One is storage costs; obviously, it costs more to store 1000 barrels of crude oil (the size of one NYMEX light sweet crude contract) until January of 2010 than until January of 2009.

The other is opportunity cost; by tying up funds for the purchase of crude oil for future delivery, these funds are no longer available for other purposes – the simplest of which is earning a risk free interest rate.
Putting it differently, a futures market will normally reflect the 'cost of carry' – the cost one incurs by holding the underlying commodity from the current moment in time to the day of delivery.

However, the futures curve also reflects other considerations; the major one is the market's perception of the state of estimated current supply compared to expected future supply. For instance, at present, the futures curve in crude oil shows an unusually large contango – so large that people are scratching their heads over it, as it allows one to make very large arbitrage profits by simply storing oil and selling it forward.

Apparently the oil market currently has two major concerns:
1. current supplies are more than ample – the market is in fact oversupplied in view of a sharp fall-off in demand.
2. the low prices of today make a far less benign supply situation in the future more likely, as many oil production expansion plans are being shelved due to the recent price collapse.

Occasionally though, and at times for extended periods, oil has been trading in backwardation – meaning, that the futures curve looked opposite to its normal shape – spot oil and near delivery months traded at a (often large) premium over later delivery months.

Whenever an industrial commodity is trading in backwardation, one can be sure of one thing: current supplies are very tight relative to demand. Backwardation discourages storage by making it very costly, and is the market's way of drawing as much of a commodity out of storage as is possible, as users need it in the here and now.
Thus the 'abnormal' situation of a backwardation in a futures market has an economically valuable function: it informs market participants of a supply shortage in the present, and by making storage a costly proposition and allowing for an arbitrage that makes it profitable to sell a commodity in the present and buy it in the future, it draws supplies out of hiding, which will eventually tend to alleviate the shortage.

A gold backwardation is different

Let us now proceed to looking at the recent backwardation in gold (in the meantime the market has reverted to a slight contango, but this seems poised to reverse again, as gold forward rates have resumed falling).
After reading the above paragraph on backwardation and contango, one might be tempted to conclude that a backwardation in gold is no different from one in say crude oil, or copper.
However, this is definitely not the case.

Many readers of this blog are probably familiar with Mike 'Mish' Shedlock's blog 'Global Economic Trend Analysis' and may have followed the recent back and forth between Dr. Antal Fekete and Mish on the topic of the recent brief gold futures market backwardation.

It began with Dr. Fekete's somewhat alarmist (but nevertheless quite interesting) article 'Red Alert: Gold Backwardation!!!', from whence it proceeded to one of Mish's frequent conspiracy-debunking blogs entitled 'Nonsense About Gold Backwardation, Ameros,Yuan Devaluations, etc.', which prompted Dr. Fekete to reply, a bit miffed, with 'There Is No Fever Like Gold Fever', followed by another rebuttal by Mish 'No Fever Like Gold Fever: Response'.

This latter article quoted me, following an e-mail exchange with Mish in which we discussed the situation. Since Dr. Fekete's article struck me as overly alarmist at the time, and I thought that the backwardation was probably mainly a short term anomaly, I was rather dismissive of the claims made therein.

For one thing, the gold forward curve is supposed to be quite flat at present – after all, official interest rates all over the world have been slashed to the bone, and this lowers gold's cost of carry commensurately – the opportunity cost of holding gold has declined sharply.

Secondly, we know that demand for small denomination physical gold has recently soared, which has surprised refineries that now have difficulties to deliver all the gold demanded in a reasonable time span.

Thirdly, it has been known for some time that gold lenders (mostly central banks) have become reluctant to lend out gold, due to rising concerns about counter-party risk.
This can be inferred from the gold lease rate, which has recently risen quite sharply. Since it is also a well known fact that forward selling on the part of gold miners has become very rare , a rising lease rate can only mean that the supply of gold for lending purposes has tightened (what little forward selling there is done is almost always tied to project development debt finance, but this is still easily overwhelmed by the ongoing covering of stale forward sales by large established producers like e.g. Anglogold, that has only fairly recently adopted a 'no more hedging' policy under its new CEO).


The LBMA's 3 month gold lease rate, courtesy of Lance Lewis. There has been a recent spike indicative of tightness in the gold lending market. click on chart for larger image

I did however mention that a backwardation had to be regarded as bullish, and I conceded that in the case of Zimbabwe, Dr. Fekete was perfectly right: it does not matter anymore how much money in terms of Zimbabwean government scrip one offers to a holder of gold in Zimbabwe - he simply won't sell. This, as I put it, is what happens once an inflationary conflagration of a fiat currency reaches the 'point of no return'.

Hyperinflations have several distinct stages that have been observed throughout history – in the course of the acceleration of inflation to ever higher rates of change, there always comes a certain threshold point – what I refer to as the 'point of no return'.
This is the point at which the public realizes that the inflation is a deliberate policy that is set to continue, for the simple reason that the government issuing the money in question is technically bankrupt.
What usually happens then is that the decline in the respective money's value begins an irreversible acceleration that stops only with the complete repudiation of the money concerned, even if the government stops printing more money, respectively prints far less than would be indicated by the acceleration in price increases.

We can actually observe this in Zimbabwe, where the government's bankruptcy has proceeded to the stage where it can not even afford the paper and ink anymore that it would need to print additional currency. Thus there is now hyperinflation (recently estimated at 500 billion percent annualized) concurrently with a deepening cash shortage.

In essence, the market has declared the government's scrip to have no value at all, and economic activity is increasingly reverting to barter.
Once the 'point of no return' threshold of an inflation is crossed, one can not hope to get any more gold in exchange for the government's scrip. One may be able to exchange other goods of value or foreign currency for gold, but not the fiat money in the throes of hyperinflation.
There may still be gold prices quoted in the inflating currency, but this is strictly a technicality, respectively illusion.

So why then did a slight backwardation in gold futures lead Dr. Fekete to exclaim that the irredeemable fiat dollar was about to meet with a similar fate? You may need some background on what makes gold different from industrial commodities – my brief article 'Misconceptions about Gold' posted under the nom-de-plume Trotsky at Mish's blog a while ago can be used as a primer.

The thing is, gold normally never goes into backwardation. One of the reasons why gold has been chosen as money by the free market is the fact that a large above ground supply exists – a supply so far in excess of the amount of newly mined gold added to it every year that it promises both to be stable and ample enough to successfully serve as money.

This large supply also ensures that normally, the gold futures curve will always be in contango – there can be no 'shortage' of gold similar to, say, a shortage of copper or oil.
The contango in gold futures meanwhile changes largely along with changes in the Fed's administered interest rates – expressing the either falling or rising opportunity cost of holding gold relative to the government's irredeemable scrip.

Copper and oil inventories can and are, usually measured in 'days or weeks of demand'. These are commodities that are used up in industrial applications, for which the annual primary supply/demand situation is quite important and determines the size of the inventory and consequently the shape of the futures curve.
There can be a shortage of copper, respectively a supply situation that is so extremely tight that a shortage seems imminent. When that happens, the copper curve will be in backwardation, often markedly so.

In light of the above, one must concede that Dr. Fekete has a point, even if he went overboard with his declaration of imminent monetary Armageddon.
If we look at the going-ons in the December GC contract specifically, it elicited a large demand for physical delivery, with about 12,000 contracts (equivalent to 1,2 m. oz.) standing for delivery in spite of a temporary backwardation that makes a 'sell now, take delivery later' arbitrage profitable.


The LBMA's 3 month gold forward rate (a.k.a. 'GOFO'), also courtesy of Lance – the only time this forward rate temporarily spiked into deep backwardation since 1990 was just prior to the announcement of the 'Washington Agreement' that limited central bank gold sales and gold lending activities; a huge short term surge in the gold price ensued. It is notable that GOFO usually tends to reach very low levels just prior to major bull moves in gold – this is only natural considering that a flattening of the forward curve is indicative of a falling opportunity cost of holding gold. click on chart for larger image

Concurrently we observe a fairly regular increase in the gold holdings of the gold ETF GLD; recently these holdings have reached a new record high of 670 tons. Over the past several months, the gold holdings of the ETF have either remained fairly stable or have risen regardless of the gyrations of the gold price itself.
This is a microcosm of sentiment among a certain – important - group of gold buyers.

These buyers represent exclusively monetary(or investment)demand, and they buy irrespective of short term price movements. Clearly, this group of buyers is very worried about the recent systemic crisis, and considers gold as an important form of insurance.

Exchanging promises for more promises

Anyone with assets to protect has probably given some thought to gold's ability to serve as a long term protector of wealth in light of recent large scale failures in the financial system.
If one has a large amount of money deposited with a bank, one has to confront the these days very real risk that the bank might go under; the bank's promise to produce one's money on demand looks a lot shakier than it once used to.
One possibility is to buy government bills, notes and bonds, something that countless big investors are in fact doing lately, inter alia because no other market is more capable of digesting very large sums without a hitch. The liquidity of the government debt markets is unparalleled.

However, one simply exchanges the bank's promise to pay for the government's promise to pay – and both the bank and the government only promise to pay in yet another promise to pay, namely the Federal Reserve's, in the form of the bank notes it issues.
Furthermore, here is where things become circular, lately with a twist. While the bank notes represent the central bank's liability, it normally has government debt on the asset side of its balance sheet – a promise to pay 'backed' by a promise to pay.

The 'twist' these days is that the asset side of the Fed's balance sheet increasingly consists of all sorts of garbage as a result of its countless special lending facilities, and fewer and fewer treasury bonds (the percentage of t-bonds has fallen from roughly 90% to a mere 22% of all assets held by the Fed).

As I have illustrated in this article that appeared at Mish's blog a while ago, this is a modern day update on the tally stick scheme.
The real 'backing' – the thing that ultimately stands behind all these promises – is the government's force monopoly, enforcing legal tender laws, the certainty that it will collect taxes in the form of this scrip and the fact that it accepts the scrip for payment of taxes (certainly no-one would accept irredeemable pieces of paper with ink slapped on them as 'money' in a true free market setting).

Investors have faith that the industrialized nation states will continue to be able to keep this scheme going, and that the possibility of government going bankrupt is remote – after all, there is a lot of accumulated wealth that can still be plundered, and also a reasonable expectation that in the long term, more wealth will be created (even though the process has met with a hitch for the moment, due to the bust that is now underway). This is certainly a reasonable expectation, based on historical experience.

However, this does certainly not mean that investors are completely discounting the possibility that the current monetary system itself could eventually fall into crisis. After all, what keeps it going is mainly confidence.
Should confidence in the system's viability evaporate, the only form of money still acceptable would be the one that is not a mere promise to pay – the money of last resort, gold.

A simmering crisis

I would in fact argue that signs of a simmering crisis of the fiat money system are increasingly in evidence. Take for instance the wild volatility of the fiat currencies relative to each other. It is as if capital were constantly fleeing from one corner of the burning building to the other (see the charts at the bottom).
Take the flight into government debt, that has taken on bubble-like characteristics. At one point last week t-bill discount rates briefly turned negative – investors were prepared to pay the treasury for the privilege of lending it money – of course, in reality they were paying the treasury for keeping their money 'safe'.

Consequently, Dr. Fekete does have a good point when he says that 'lasting backwardation in gold is tantamount to the realization that ‘gold is no longer for sale at any price’. (emphasis mine).
The important point is 'lasting' – the recent backwardation looked more like a short term aberration, a technicality basically, but was perhaps also a first warning shot regarding what may lie in store in the future.

Conclusion:

One should keep a close eye on the gold forward curve. Should a backwardation eventually become deep and entrenched, it would be a strong signal that the financial crisis has progressed to the point where the monetary system itself becomes the center of attention.

Below a number of charts illustrating the 'simmering crisis' situation. click on charts for larger images

currencies:


Wild gyrations in the Swiss Franc. As both a 'safe haven' and former carry trade currency, it is especially prone to sudden explosive moves.


The Yen has gone ballistic – this is the highest level since the 1995 spike high.


The dollar index – from overbought to oversold within days – the recent correction looks more like a crash than a correction actually. The recent moves in currencies are not indicative of a healthy system. One should add that these moves are exacerbated by the actions of trend-chasing quant funds, most of which usually tend to end up sitting on the same side of the boat just before it capsizes.

government debt:


The US treasury long bond - can you say 'buying panic'?

central bank data:


The sudden death of monetary prudence – base money is now growing at a 360% annualized rate


A longer term view. One can see both the Y2K monetary pumping panic (which gave us the blow-off phase of the Nasdaq bubble) and the post 9/11 spike. Both spikes used to really stand out on this chart as historical aberrations. No longer.


A few more charts from the Fed highlighting the situation.

GLD:


Gold holdings of GLD via Lance – a new all time high.

Should we return to the gold standard?

We are living in what one could no doubt dub 'interesting times' ('May you live in interesting times' is a famous curse ascribed to the Chinese, although its origins are disputed). Our entire financial system is under siege – many eminent banks and broker-dealers , some of which survived even the Great Depression of the 1930's have either gone bankrupt or have barely escaped this ignominious fate by being taken over by stronger rivals (often at the 'suggestion' of officialdom).

Governments all over the world have taken steps to not only guarantee all bank deposits (a guarantee which probably only 'works' as long as no-one calls on its fulfillment), but have also force-fed 'capital' to not-yet bankrupt banking institutions in a bid to avert a total seizure of the credit system.
In the meantime, the crisis has begun to engulf entire countries – Iceland, Hungary, the Ukraine, Pakistan, Argentina (once again) are in various stages of extreme financial and currency distress, with some of them having been pulled back from the brink by emergency loans from the IMF (or in Hungary's case both IMF and ECB), and at least one apparently having entered a state of national bankruptcy already (Iceland).

As previously chronicled, there has been a tendency in the press to blame the free market for the calamity – in a sort of 'we had too much of it' manner. These days we are even treated to the spectacle of 'eminent Marxist historians' being released from their crypts and asked for their considered opinions.

However, one also notices that lately some have begun to question central bank policies – specifically those during the Greenspan era. Once upon a time the 'maestro' could do no wrong – congressmen even found it funny that they usually couldn't understand what he was saying (who once remarked: "I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said."). He himself once opined that the central bank under his guidance had 'managed to emulate a gold standard' , when questioned by Ron Paul regarding the apparent evolution in the beliefs he once held.

Naturally, one might ask: if the central bank's goal is to emulate a gold standard, why not just have a gold standard instead? Should we not, instead of leaving decisions about interest rates and the supply of money to a gaggle of bureaucrats , rather trust the historically well established monetary discipline of gold?

Actually, it is the wrong question to ask. It should be reformulated thusly: should money be regulated and administered by the State, or should it be left to the free market?

How much money is enough?

If one looks at modern monetary theories, some things immediately stand out: it is implicitly assumed that the central bank-led, state controlled money system is somehow 'inevitable', and that the money supply should always grow, just not by 'too much' (it is held that there are various ways of achieving this, like e.g. the 'gold price rule' favored by monetarists , which is criticized here).

Most people complain about inflation (this is to say, they complain about rising prices, one of the effects of inflation), but they regard it as a necessary evil that can't be helped – as if it were a sort of permanent natural disaster. As i have explained in my essay about fiat money on Mike Shedlock's blog, there is a reason why fiat money is seemingly workable at all, and there are political – not economic – reasons for why it exists.
It is important to realize that money is not a creature of the state. It did not come into being by state fiat, it has come into being via market processes. Historically, a commodity has been chosen as money, and such a commodity had to have a pre-existing demand, i.e. it had to be useful by itself – otherwise there would be no reason to accept it in payment.
The medium of exchange, which is money's primary role, is the foundation of the modern market economy, enabling the division of labor and a roundabout, complex production structure, something that would be nigh impossible in a barter system.

Often people assume that the money supply must grow, because otherwise, there would simply not be 'enough money' for all the goods and services that are produced in increasing abundance.

To this Ludwig von Mises said: ' No increase in the welfare of the members of a society can result from the availability of an additional quantity of money' (Theory of money and credit, p.102) and 'The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do. ' (Human Action, p.418,421),

Many people would probably consider these to be extraordinary claims at first glance. Consider though what money is supposed to do: its function is to facilitate exchange. From this flows its secondary function as a 'store of value'.
If for instance a producer of perishable consumer goods wants to save, money facilitates this act of saving for him. No-one holds money for its own sake – it is held for the function it promises to fulfill - namely to make the exchange of goods and services possible.
Let us now in this light look at the idea that an increase in the quantity of money confers no social benefit on society as a whole. Assume that for instance, the Federal Reserve were to credit every one of us overnight with an amount of money equal to the amount we already possess – effectively doubling the money supply. Would we be richer than before? Not if the supply of goods and services had not also magically doubled overnight. It stands to reason that such an act by the Fed would almost immediately simply lead to a doubling of prices, given that the supply of goods and services would stay the same and everybody would soon be aware of the doubling of the money supply. This is of course only a hypothetical thought experiment intended to show that it is not the quantity of money that determines our wealth – wealth consists instead of the amount of real capital and real goods and services available.
The workings of inflation are a bit more complicated – and a lot more damaging - than suggested by this thought experiment.

With regards to the first statement – that the total amount of money in the economy at all times is sufficient to secure for everybody all that money does and can do – let us consider a hypothetical free market in which gold is used as money.
It should be clear that like any other good, the money commodity is subject to the laws of supply and demand as well. Thus the money supply would not be entirely stable in a free market either, and both the value and the supply of money would respond to market-based changes in the demand for money.
It is probably safe to assume that a gold-based money supply would only change slowly overall. What then, if the demand for money were to rise, removing some money from circulation? The market response would be two-fold: the value of the money unit would rise, and gold mines would thereby be induced to produce more gold to satisfy the higher demand. The existing stock of money would continue to be able to fulfill its function of securing the services expected of it – after all, what people care about is not the number of gold ounces (or money units, generically) they possess, but what those ounces or money units can actually buy.

We can conclude that Mises was correct – in a free market dispensation there could never be 'not enough' or 'too much' money – the market itself would regulate the supply of money and money's value though market based supply and demand processes.

As an aside, one of the reasons why we know that the market still regards gold as money, even in our modern , legal tender fiat money world, is that exactly the same thing happens nowadays during periods of increased monetary demand. Take for instance the current economic bust, which is characterized by a sharp rise in the demand for money due to increasing uncertainty about the future and the need to repay debt.
One of the things that has happened is that while gold's nominal price has corrected from previous highs, its real price – as measured by the amount of non-gold commodities gold can buy – has risen sharply. This increase in gold's purchasing power is raising the profit margins of gold mines, giving them an incentive to increase production.
How can we explain that gold still acts as if it were money, even though it is not used anymore as an officially sanctioned medium of exchange?
Presumably this is because the market regards gold as the 'money of last resort' – the pinnacle of the inverted monetary pyramid, that would revert to becoming the money supply if the fiat money system were to falter.



gold versus commodities - gold's purchasing power has increased. click on chart for larger image.


The problems of the centrally planned money system

It is odd that modern-day economists seem to be largely of one mind when it comes to the benefits imparted by the capitalistic free market system – for instance, there is almost universal agreement that it is a bad idea for the government to run any kind of business – but they all stop short of extending that thought to money itself. Somehow they seem to believe that bureaucrats are more capable of managing money than the free market would be. For a mainstream economist to suggest otherwise is almost akin to farting in church – it is a taboo subject.

If one wants to understand why this is so, one must consider the reason for the establishment of a fiat money system. As mentioned above, the reason is political, not economic. It is the fiat money system that allows the almost unchecked growth of the state, by enabling it to borrow money into existence that it would otherwise have to garner by taxation alone. Inflation of the money supply is a tax that is not declared as such, and it is a way of redistributing wealth – after all, inflation of the money supply is not instantaneously transmitted to everyone by increasing everybody's money by the same percentage at once as in our thought experiment above, but there are 'first receivers' of the new money being created, which enables them to bid for resources before the rest of the world realizes that money has been diluted. They therefore enjoy an advantage insofar as they can buy goods and services before their prices rise. In short, the fiat money system is one of the ways in which favored groups within society can be bought off, at no cost to those in control of the money system (the economic cost for society as a whole is however grave).

In theory, the establishment of a nominally 'independent' central bank is designed to keep money supply growth in check – as the central bank is usually mandated to 'ensure price stability'. As we will see, this mandate makes no sense – it can not keep the central bank from inducing boom-bust cycles, in fact, it likely makes them more severe.

Whatever one may think of Ben Bernanke's economic theories, specifically his view of the depression era ( i believe he has come to the wrong conclusions about that episode), he has been trying up until recently to run a not-too-inflationary, relatively tight policy. For instance, the various special financing facilities by which he has transformed the Fed into a warehouse for suddenly illiquid bank assets of questionable value, have originally been put in place in such a way as to not increase the supply of money – the Fed simply exchanged one type of securities (t-notes and bonds) for another type (mortgage backed garbage).

In fact, both Ben Bernanke and probably even more so Jean-Claude Trichet who heads the ECB can be considered to be well-meaning civil servants who are taking their mandates seriously.
The problem is that the fractionally reserved banking system as such is geared toward inflation of money and credit. The moment a commercial bank extends a new loan, new money is created when the proceeds of the loan are deposited into the account of the borrower, a deposit that can then be used by the bank receiving it as the basis of a new loan, and so forth. Over the many decades this system has been in operation, an incredible amount of financial claims – and money - have been created.

Another problem is that no matter how well-informed the monetary bureaucrats are about the going-ons in the economy, and no matter how well they think they have adapted their methodologies to the needs of same (there have been various approaches adopted over time, from money supply targeting to interest rate targeting), their decisions regarding e.g. what interest rate to set, must perforce be inferior to a market-based outcome. Since there is political pressure to keep interest rates as low as possible (i.e. as low as they can be without raising the 'inflationary expectations' of the public at large) , there will be a tendency to undershoot the natural interest rate most of the time.

In short, the system will tend to inflate the supply of money and credit. Let us now consider why this leads to damaging boom-bust cycles . In a free market, banks would merely be middlemen helping to channel savings from those who have them to those that require credit.
Savings are not 'money' – they are production that has not been consumed. This unconsumed production can be exchanged for money, which obviously is quite practical. The fact remains though that what has been saved is not 'money' per se, but that money is a place-holder for saved production.
Saved production is what sustains the economy's complex structure of production – it is the real subsistence fund. How the subsistence fund works has been explained in detail by Frank Shostak here, using simple, easy to understand examples.

When deposits are expanded by credit created out of thin air, they are not backed by preceding production. In short, there is now money in circulation that is not a placeholder for saved production – but it can still be exchanged for real goods. These 'exchanges of nothing for something' then begin to distort the economy's structure.

The natural interest rate that would prevail in a free market imparts important information to entrepreneurs : it tells them of the state of time preferences and the consequent amount of real savings available to the economy. Time preferences have to do with the basic idea that present goods are more valuable then future goods – an apple available for immediate consumption is more valuable than one available for consumption at some point in the future. When people's time preferences are low, they will save more relative to what they consume, and the larger pool of available savings will lower the natural interest rate. This is a signal to entrepreneurs that they can undertake longer-lasting capital projects, involving the production of higher order goods – the production structure can be lengthened, and more roundabout production processes will come about. Investment will therefore gravitate toward such higher order goods production, while less investment will be available for lower order, i.e. consumer goods production.

This will ultimately make more consumption possible in the future – the growing amount of real savings sustains higher order goods production, which then increases productivity, making more consumer goods at lower prices available in the future. There is however a constant interplay in this allocation of resources along the production structure, whereby changing time preferences, which lower and raise interest rates, tell entrepreneurs whether to produce more capital or more consumer goods. Remember that the amount of consumption goods saved must be sufficient to sustain those involved in higher order goods production for the duration necessary to implement their investment plans.

From the above, we can summarize the problems that a centrally planned fiat money system produces:

1.one of the effects of inflation, namely rising prices , leads to a redistribution of wealth to those who are first receivers of newly created money from those who receive it later. Prices will never rise uniformly, and will do so with a considerable time lag, and it will always be difficult to judge which price rises are a result of inflation and which are merely a market based signal of demand exceeding supply. However, some groups in society will profit from this, while others will pay for it. Those that pay are generally on the lower rungs of the economic hierarchy.

2.another – the even more damaging effect – is the one on economic coordination. Since entrepreneurs get false signals by means of artificially low administered interest rates, they will channel too much investment toward higher order goods production, distorting the production structure. Capital will be malinvested, as the artificially low interest rate implies levels of future demand that can not be sustained by the state of real savings. This will create a boom, but the boom will turn out to be artificial. The boom is really an artifact of capital consumption – this to say, previously accumulated capital will be consumed as artificial economic activities that would not be sustainable in a free market are undertaken on account of too low interest rates and the creation of money and credit 'out of thin air'. These activities bid scarce resources away from where they would be more profitably employed. Eventually, these economic errors will be revealed, either when the central bank tightens policy, or when the pool of real funding becomes so strained that malinvested capital can no longer be sustained no matter what.

The current situation

In recent decades, central banks have adopted interest rate targeting as their favored method of regulating money. This is best described as a price fixing scheme.
One of the goals officially pursued by this policy is 'price stability' – a very amorphous concept, since prices are supposed to fluctuate in a market economy, and a measurement of 'aggregate prices' is not really possible – we only pretend that it is (if you add up the price of a bag of rice, a car and a hair cut , the result will be a nonsensical number).

Still, the declared intent of the policy is to avert both a fall as well as an untoward rise in the mythical 'aggregate price level' – mind you, 'price stability' is not intended to mean that prices should not rise at all, only that the rise should be capped at some arbitrary percentage every year. In other words, the frog is supposed to be boiled slowly (you, dear reader, are the frog).

At times, increases in productivity will be very rapid – this happens usually when new industries and new industrial processes are introduced after a large leap in technological progress has taken place, and when global trade intensifies, making use of comparative advantages , and furthering the division of labor.

This happened e.g. in the 1920's ,when the car, the airplane and the radio changed the economic landscape, in addition to a modernization of factory production processes, and it happened again in the 1980's and 90's with the advent of the PC, the cell phone, the internet, and connected industries.
In both eras, central banks made the mistake to keep their interest rate policy too loose by pursuing 'price stability'.

In reality, the huge increases in productivity helped to mask inflation, as they exerted downward pressure on prices. Had interest rates reflected actual credit demand as well as time preferences during these eras (which were inter alia marked by sharply rising consumption), rates would have been much higher, and prices, instead of being 'stable' would have fallen instead, reflecting the strides made in productivity increases.

However, underneath the 'disinflationary boom' ('disinflation' is a term divorced from the real meaning of inflation and deflation, meant to describe aggregate prices that rise at a continually decelerating rate of change), inflation actually raged, as the money and credit supply literally exploded. Partly this was reflected in asset prices, which rose like never before, and helped support even more credit expansion, as inflated assets could be used as collateral for more credit. While this was going on, everybody was convinced that a virtuous cycle was underway, while in reality, capital was increasingly malinvested on a large scale.

The recent credit and asset boom reached pinnacles at different times in different parts of the globe, with Japan's combined equity and real estate boom the first to flame out in the late 1980's. The reaction of Japan's policy makers to the bursting of the Japanese twin bubbles helped to set off a fresh round of malinvestment elsewhere in the world, as the Japanese authorities began to inflate even more. Interestingly, although the BoJ eventually expanded base money by over 200% and the state went on an unprecedented fiscal deficit spending spree , Japan's commercial banking system was barely able to create more credit inside Japan (at one point, bank credit contracted for 60 months running). It was clear from this, and from the stock market's inability to re-inflate in spite of the lowest interest rates in the world, that Japan's pool of real funding had suffered enormous damage during the boom.



Japanese monetary data, chart via Bruce Carman. Note how a large increase in Japan's monetary base via so-called 'quantitative easing' failed to increase the broader M2 measure or have any appreciable effect on economic activity (click on chart for larger image).


Next was the technology boom that flamed out a decade later, with stock prices in the Western world reaching unheard of levels and price/earnings multiples. Similar to Japan's situation a decade earlier, rationalizations for this phenomenon were plenty, but the truth was of course that inflation of money and credit drove asset prices to the stratosphere, just as had happened in Japan.
When this boom faltered, it soon became clear that the US pool of real funding had to be in trouble as well, as stock prices continued to precipitously decline in spite of the largest and fastest reduction in US and European interest rates ever.

This decision by the authorities to fight the bust of the inflationary boom with even more inflation managed to create a third boom phase, this time centered on real estate, commodities and emerging market economies. Given the extremely low US savings rate and the fact that the US current account deficit led to a sharp rise in the foreign exchange reserves of surplus countries (mostly in emerging market economies), and the often cited statistic that 'the US needs 80% of the world's savings to finance its current account' we can reasonably assume that this global third boom phase managed to deplete, resp. severely damage, the pool of real funding of the rest of the world as well. In other words, an inflationary expansion in money and credit has led to global capital consumption and malinvestment on a likely unprecedented scale.

Since we can not measure the state of the subsistence fund directly, we have to draw inferences from what happens when monetary and fiscal pumping is employed to counter the ongoing bust.
So far, the outcome is very sobering. Central banks have given up on the idea that they should not inflate, and are pumping all out – interest rates have been slashed to the bone, and various monetary measures under the central banks control are soaring. Governments have either already spent or pledged enormous amounts to turn the faltering economic and financial ship around. In spite , or maybe because of all these interventions, stock and commodity markets have crashed globally.



the US monetary base, 1918 to present, via Bruce Carman. the current amount of monetary pumping is unprecedented. click on chart for larger image




the current composition and growth of the asset side of the Federal Reserve's balance sheet. note that the US dollar is what the Fed's liabilities consist of. the dollar is beginning to resemble the French revolutionary assignat by now (the assignat was 'backed' by confiscated church property, the dollar is increasingle 'backed' by mortgage debt securities). click on chart for larger image.

The chances for re-igniting the boom must be regarded as slim in light of the above. The markets are signaling that economic activities that do not generate wealth can't be revived by means of monetary pumping, a strong sign that the global subsistence fund is in trouble and in need of rebuilding. The best way of achieving this necessary rebuilding would be to let the market do its work, as painful as that would be in the short to medium term in light of the previous excesses.
The point here is that the disease can not be cured by administering more doses of the poison that created the disease in the first place – easy money.
Should the boom against all odds be re-ignited quickly, it would merely set up an even bigger bust down the road – however, this does not seem probable, since this time we would have to draw on the subsistence fund of Alpha Centauri, or wherever it is the aliens live.

Conclusion

We can therefore give an answer to the reformulated question posed above: should the money system be freed from government control and be returned to a free market dispensation? The answer must clearly be yes.
Note that such a transition would not be painless either, but it would nevertheless help to restore the economy a sound footing very fast. We can not say for certain whether gold would be the basis of a free market money system, but considering the historical record, some sort of metallic standard (perhaps a mixture of various metals) would likely emerge. This would by no means mean the end of a modern financial system – on the contrary, since it e.g. seems unlikely that we would start lugging around gold coins in our digital world (the practical implementation of a return to sound money will be the subject of a future blog).

Under a free market money system, the world would likely enter a period of what some refer to as 'benign deflation' , which is to say, prices would fall over time, reflecting increases in industrial productivity. Everybody would gain in terms of real wealth. The same can not be said from a world in which inflation of money and credit continues to be the preferred, government-imposed policy.



Assignat of the French Revolutionary government click on chart for larger image



the form of money most likely to be used by the free market click on chart for larger image