Humor me. Let’s crunch those numbers.

Those gold certificates have a book value of about US$14 billion, if you include special drawing rights and coin holdings ($1.7 billion). Even if you revalued this inventory, it would still total less than $300 billion, or 12% ofthe Fed’s total assets. So far, that’s a weak defense against our allegations. And it only goes downhill from there. Assuming it still got the goods at all, a lot has changed in just three months. In August, this gold had a market value that represented over 30% of the Fed’s assets.

Back then, additionally, U.S. Treasury securities still made up half the Federal Reserve’s asset base.

Today, however, in a very short space of time, the market value of both of these assets together comprises just 30% of the central bank’s total assets. It is fruitless to discuss what makes up the rest of its “portfolio,” because whatever it is, it is of lesser quality — aka higher risk.

His proposal was interesting, however, for other reasons. In case you missed its inference, the idea of a revaluation in gold reserves on the Fed’s balance sheet is to boost confidence. It is but a keyboard stroke away, a technical matter. Most analysts already take gold’s market value into account anyway.

Still, two outcomes of such a revaluation occurred to me over and above the obvious, I think.

The first: It would align the Fed’s interests with gold prices — by increasing gold prices, it would boost the value of its balance sheet, for instance.

Second, it would inflate gold’s perceived importance — an endorsement of sorts, in the eyes of the Fed. The public and the market would have to reassess their fundamental outlook about the importance of gold, too.

On the surface, Gramley’s proposal aims at making the Fed look like some kind of gold standard bank. But in fact, this kind of thing, especially if it were spun out in reaction to a crisis of confidence, might be so bullish for gold that it sinks the Fed.

If Bernanke were smart, he would want that gold to disappear off the balance sheet without notice.

But let’s forget about what would be bullish for gold and point out what in fact is the fear of deflation.

The Great Reinflation Update

In December, the Fed shoveled another couple hundred billion new Washingtons into the banking system, out of its many open windows. B-r-r-r!

Its balance sheet expanded to over $2.3 trillion as of last week’s report, which came out the day after it decided to cut rates to nothing. My guess is that we’ve seen nothing yet. You thought “cheap money” was bad. This is the era of FREE money. This stuff grows on trees. You don’t even need choppers. Already, despite the intensity of the deflation rhetoric, the money supply numbers continue to point the other way — toward the Great Reinflation. Or should we say “because” of the intensity of the deflation rhetoric!

This week’s money supply numbers suggest the alleged credit freeze continues to thaw.

After stagnating with little or no growth, stuck at under $1.4 trillion over the past four years (since the Fed began hiking rates in 2004), even as the Federal Reserve started cutting rates in 2007 again, U.S. M1 has grown by over $130 billion, or 10%, since August alone. That’s when it stopped sterilizing its “liquidity” injections. But this kind of growth in three months is a record. Percentage-wise, too.

Most of that growth, moreover, is occurring in checkable (demand) deposits. U.S. M2 is growing at almost $100 billion per month, and it is approaching a 9% year-over-year growth rate — its strongest growth since early 2002, midway through the Fed’s last reinflation effort (2001-03).

Most of that growth is occurring in money market fund holdings.

The definitions of money supply that I put stock in suggest that the banking system is inflating deposits at roughly5% year over year, but of special significance is that this growth rate is picking up now.

It certainly is not as robust as the narrow measures of money or the Fed’s balance sheet.

But it is not deflation.

I promise to keep looking for it, nevertheless.

Contrarian Bet on Oil ETF Calls Has Attractive Risk-Reward

New lows in oil prices drove the value of the United States Oil Fund to a new low on a couple of weeks ago, when I put out my buy recommendation on the April 2009 $35 Calls (UBODI). This is still a good time to be picking away at those calls, in my opinion. But this kind of thing is not for the faint of heart.

Options are very volatile. I never put in any more than I’m prepared to lose on a given situation, and the risk-reward ratio has to be very attractive. This trade fits the bill. I continue to believe we should be taking advantage of the extremes in the market today. I think they are being driven by irrational fears over deflation. My conviction is strong about that. If you’re with me on this, you just have to be buying the biggest and fastest drop in oil prices in decades. In less than six months, you’ve seen oil prices fall from $147 to as low as $32 in some contracts last week, for a 75-80% drop in value.

I mean the market has discounted a lot of bad stuff. Sure, we could drop another $10 in an instant and those calls could go to zero. I didn’t say there wasn’t risk in the trade. However, I think four months is enough time for a return to normality. Whether we drop another $10 in the oil price or not, if it can drop more than $100 in five months, it can rally $20-30, or more, in four, especially if we are right about the deflation bogeyman.

But forget about that. It’s all technical. We’re not betting on any new highs here, just a return to normality. It’s a contrarian call, and it’s risky, but if we’re right, the price of oil should be back up above $60 by April. The U.S. Oil Fund could nearly double in such a situation, and the April 2009 $35 Calls, which you can buy for $3.50 today, would be intrinsically worth near $20.

That’s 300% upside from my purchase price, but it is closer to 500% from today’s price.

I would continue to buy April 2009 United States Oil Fund $35 Calls (UBODI).

Please note that these calls have no intrinsic value while USO shares trade below $35, and there is no guarantee that if oil goes up USO will gain the same amount. It is an ETF that invests in oil and has matched the movements in oil, more or less, so far. Moreover, in buying these calls, I am fully aware that we are going against the trend on the chart, but in my experience, such trends are not very definitional or sustainable in times of market panics or extreme volatility. This is a contrarian, bottom-fishing bet based solely on my instincts as a trader.

I’m sure you’ll hear from me again soon, but let me take this opportunity to wish you a safe and prosperous new year.

Regards,
Ed Bugos

January 7, 2009

The Great Reinflation was originally featured on Whiskey and Gunpowder

Facts: The open interest in futures contracts on the Comex has fallen to its lowest level since summer 2005, breaking a general uptrend in place since 2001. From a contrarian standpoint, the short-term bottoms in these data tend to favor the buyers over the sellers. However, the statistic went into orbit during the last half of 2007 — it broke away from the upper channel on the charts, creating a bubble in appearance. The current extremity could simply be a symmetrical reaction to that extreme.

Nevertheless, this is a bearish fact, technically speaking, if it represents a lasting new trend.

It is tempting to suggest that the threat of a raid in futures contracts is causing a short squeeze.

It is true that the commercials are liquidating their short positions promptly. But the funds are increasing their short bets, and the liquidation of longs is such that the net short ratio has hardly budged off its mid-September low — which, incidentally, is a level that has coincided with strategic buying points at seven other junctures since the bull cycle began in 2001.

However, the record of this statistic in gold is unique in that during bear markets, the commercials tend to be net long (wrong) most of the time.

So the fact that they are covering their short interests on net does not necessarily presage a rally if a bear market has set in. A bear market would mean that gold prices could fall as far back as US$500.

Fundamentally, the conditions just don’t look ripe for a bear.

I don’t believe the COTs (Commitment of Traders report published by CFTC) have any real predictive value. They tell us only whether the market is too much extended one way or another; they don’t tell us how long those conditions will last. Right now, the structure of the market is healthy. The commercials are covering their shorts, the funds are getting short and the numbers basically favor the bulls. The contraction in open interest worries me a little, but it could be explained in terms of a collapse in spread trades linked to various index products.

In its most recent report on gold demand, the World Gold Council said as much in trying to explain the drop in the gold price in the context of soaring physical demand. In its third-quarter report on gold demand, the WGC noted growth in both jewelry and investment demand across the spectrum relative to both the last quarter and the year-ago quarter. I don’t want to go into a critique of the method here, except to point out that it chronically understates investment demand and overstates jewelry demand.

The inclusion of ETFs all but proves the point.

In just one year, investment demand has grown in importance from under 15% to over 30% of total gold demand, causing the deficit (supply shortfall) to grow nearly tenfold. The WGC interprets this deficit as supply coming from speculative sources, like futures trading or changes in inventories at the various exchanges — like at Comex. Thus, it calls it “inferred investment.” Formerly, it called this the “balance.” But as it grew, the WGC decided it meant something. What is causing it to grow, aside from growing demand in general, is that while the WGC is “identifying” new kinds of demand, it has not kept up with the various sources of supply. Gold bugs have argued for years that the supply of gold is not limited to mine production, officialdom or scrap… that it is not like other consumable commodities.

It is more useful to assume that most of the gold ever produced is held as a reserve, or store, aboveground. And if this is true, then investment demand must be much larger than the WGC calculates, or the price would, frankly, never go up. If the WGC is smart enough to include producer hedging (or dehedging) in the equation, it should also include a measure of demand that expresses itself through all the exchanges and bring itself up to speed on all the sources that supply the market. It assumes that jewelry demand dominates the market, which is incorrect, but even if it were, it still has the wrong idea.

Jewelry demand may be price sensitive in the short term, yet it has grown every year, at successively higher prices, since the bull market began. Despite my objections, however, I am in total agreement with the council’s explanation why gold prices have fallen despite the evidence of soaring gold demand:

“Notably, the selling captured by the [inferred] investment category was mainly by investors with a short-term focus. It largely reflects the fact that gold was caught in the downdraft of other commodities and other assets — it does not reflect a questioning of gold’s value or role as a safe haven. The strong buying in the ETF and bar and coin markets during the quarter, which reflects investors with largely a longer-term focus, suggests that investor belief in gold’s role as a safe haven and store of value is stronger than ever.”

Morgan & Citigroup Gold Analysts Bullish on Gold Regardless of Dollar

No wonder the commercials are covering. The establishment is getting hot for gold.

PMorgan’s gold analysts “urged” investors to stock up on gold this month, citing counterparty risk and tight supplies. See the article here.

Citigroup’s foreign exchange group also put out a bullish tout.

Well, that’s an understatement, actually. “[Gold] continues to look like a bull market to us. We continue to believe that a move of similar percentage to that seen in the 1976-1980 bull market can be seen, which would suggest a price north of $2,000,” Citigroup’s FX group said last week.

What I found particularly intriguing, besides the timing of these calls, was that they both discounted the dollar. That is, they noted, as I have in the past, that the foreign exchange value of the dollar may not be important at this stage. Morgan said, “It is not an absolute given that a rally in gold means a falling U.S. dollar,” while Citigroup pointed out, as I also have, examples of just such a situation during the 1970s.

Anyway, it’s not a sure thing yet, and it all makes great fodder for the bull market in gold.

Regards,
Ed Bugos

December 18, 2008

Bulls Rev up for Comex Raid, Commercials Exit Stage Left was originally featured on Whiskey and Gunpowder

The rally was a no-brainer. There is a strong line of support at $700, which was resistance during 2006 and the first half of 2007. Moreover, the market was, and is, oversold.

The catalyst was news that the U.S. government had to bail out Citigroup, the world’s largest bank by revenues. The event has given way to new concerns about the economy, which weighed on stocks and gold this week, or at least provided an excuse to take some profits in the latter.

The big question now is whether it was just a retracement rally that ultimately gives way to new lows or whether we have seen the bottom in gold, with this rally being only the first of many to come.

I don’t think the chart can answer that question alone. Technically, the structure of the market is healthy now, and as far as the fundamentals go, gold should not remain under $1,000 for very long.

Indeed, I sense the market is building up for a very bullish move.

Allow me to touch on some of the bullish factors coming into play.

Deflation Scare Past Its Apex

“Notwithstanding the many developments on the bailout front during the past six weeks, The New York Times, like other media outlets, continues to quote Wall Street insiders who report” [that] “‘You have a market that is frozen.’ What planet do these guys live on? It certainly is not the same one to which the Federal Reserve’s data apply. I’ve been singing this song for many weeks, but I’m going to keep singing it until somebody in the news media wakes up and realizes that these ‘frozen credit market’ tales are pure hooey. Look at the data, for crissake.”

– Robert Higgs, author of Crisis and Leviathan, in a recent essay on the bailout programs

The fundamentals are significantly bullish for gold. I’d like to say they are bearish for the dollar, but in truth, they are increasingly bearish for all paper currencies. Outside of the Bank of Japan, everyone is inflating madly. In the G-7, narrow money (M1) is growing at 7-10% on a year-over-year basis in the U.S., Canada, the U.K. and Australia — more in developing countries like China. And this rate is picking up now.

October’s data are not in yet for the ECB. Its balance sheet increased by some 400 billion euros during the month, which is the first big change since the second quarter, and will probably reflect in M1. The Bank of Japan started inflating M1 again in September too, after holding it steady for most of the year.

The broader monetary aggregates (i.e., those determined by the banking system at large) are growing briskly everywhere but in the U.S. and Japan, though even the latter are still growing.

Broad money in the U.S. is growing between 5-10%, depending on whether you rely on TMS or MZM or higher, if you like M3 (I don’t).

The U.S. data are good through October. Up till the end of September, as far as we are updated, the year-over-year growth rate in broad money approached 20% in Australia, its highest rate in almost 20 years. In the U.K., the broader monetary aggregates are growing at close to 14% on a year-over-year basis, which is its highest growth in almost a decade.

These growth rates are almost as bad as China’s, which is approaching 20% year over year too, again. Given these numbers, it is no surprise to me whatsoever that the yen is the strongest currency, followed by the U.S. dollar, or that the Aussie and the pound are taking the greatest beatings, along with all the other riskier currencies.

The actions governments are taking now are bearish for stocks and bullish for inflation. But they are not just bullish for inflation — they are remarkably bullish.

I don’t mean to sound happy about it. It’s just an observation that the market has yet to come to terms with. Since September, the Fed has expanded its balance sheet a total of $1.3 trillion. Of that total, it has created about $600 billion in reserves out of thin air.

Most of that is not counted in money supply, because it excludes deposits held by depository institutions. Total money supply is about $6 trillion, if you rely on the Austrian School definition (I do). It has, nevertheless, translated into growth of about $100-200 billion in new money created by the banking system since September already. Deflation is a no-show so far, and I don’t think it will arrive at all. I think history will see this as just another scare.

The Federal Reserve just announced two new programs that commit it to another $800 billion, and that is even before President-elect Obama puts his stimulus package together.

Reuters cited Wachovia’s chief economist:

“Some, however, are worried the mounting costs of the measures, which have the potential to reach several trillion dollars, could eventually fuel a troubling inflation.

“‘It may mean (a) longer-run issue with inflation and inflation concerns,’ said John Silvia, chief economist at Wachovia Securities in Charlotte, N.C. ‘It may be too much of a good thing is a bad thing.’”

Ya think?

Even more inflationary, in my opinion, is the fact that the talking heads think the Fed’s latest facilities are simply not enough. They are complaining the programs do not include direct purchases of credit card debt and mortgages in the secondary market and that the Fed isn’t going to buy mortgages with maturities of more than one year. Not long ago, the Fed never bought anything but Treasury notes.

Regards,
Ed Bugos

December 17, 2008

Gold Looks Bullish as Dust Settles was originally featured on Whiskey and Gunpowder

As far as deflation goes, we saw that the Federal Reserve inflated its balance sheet by an astonishing U.S.$600 billion (almost 70%) in September, $170 billion of which ended up as an un-sterilized liquidity injection into the financial system — also unprecedented any way it is measured.

It is almost as much as the entire U.S. banking system created in the 12 months ending August 2008. It is about 20% of the cumulative amount of reserves the Fed has directly injected into the banking system since its inception in 1913. In one month, the Bernanke Fed “printed” MORE money than the Greenspan Fed in its entire easing campaign from 2001-03 — on top of which the banking system created $1.5 trillion.

Let me be the first to tell you that this represents a deliberate and abrupt change in monetary policy.

The Fed is no longer sterilizing its liquidity injections by selling off assets — probably because it doesn’t have any left. No one else seems to have caught on yet. The Fed is now printing with abandon, as literally as that can mean.

However, that isn’t enough to convince the deflationists. They point out that banks aren’t lending and that credit markets have frozen all over the world.

This is obviously true. However, it does not follow from this that there will be deflation. Let me reiterate that first, whether deflation comes about or not (I think not), the financial crisis is deepening precisely because, up until last month at any rate, the Fed had not created much money, despite the massive rate cuts. This policy was unconventional and deliberate. It was aimed at gold.

It has produced many things that the Austrian business cycle theory would predict from the policy.

The enterprises that are failing today are boom dependent. They have come to depend not only on the artificial stimulus of lower interest rates, but on a continued expansion in credit and money supply.

Indeed, Fed and Treasury officials, the media and Wall Street all talk as if the economy could not grow if the banks were not producing new credit. For them, boom and growth are one and the same thing.

The market is telling you that some operations are uneconomical in the absence of this “stimulus.”

If the Fed continued on its austerity program (with respect to the printing press), the dominoes would no doubt continue to fall. This would be a process of returning the economy to equilibrium, if you will.

That is the definition of a bust or recession. It would probably be deflationary.

The Fed wasn’t aiming for that. It wanted only to put the squeeze on inflation expectations building in the gold and currency markets without undermining the boom. It was a bold and new move, but naive. But its actions can only suggest that it is realizing this, and is not prepared to do what is right — nothing.

Lending strikes are not new. They are typical at the height of a crisis.

The Fed has published data on reserves only up until the third week of September, so it does not yet reflect the $170 billion net increase in reserves created by the Fed through the entire month, as I had reported last week. However, up to Sept. 24, the Fed created some $84 billion in reserves, while the figure for total reserves increased by $67 billion (from $44 to $111 billion) in the same period.

Excess reserves, meanwhile, increased by about the same amount.

Don’t get caught up in the numbers. These facts essentially support the view that banks aren’t lending out those new reserves. However, this fact is neither new nor typically long lasting.

U.S. depository institutions are required to have about 10% of their checkable demand deposits at the Fed as reserve. This amount peaked at a little over $60 billion in the mid-‘90s, declined to about $40 billion by the end of the century and has hovered around that number ever since, as if inflation did not exist. It pales in comparison with the more than $1.5 trillion in reserves that the Fed has pumped into the banking system in its entire 95-year history or the $4-5 trillion in deposits that the U.S. banking system has created on top of that in the same period (even after accounting for deposits destroyed).

This is leverage, but the Fed, not the stock market, controls the denominator.

The reason that total reserves have been shrinking has to do with reserve requirements. Although savings deposits are often checkable in practice and can be accessed by debit cards, banks are not required to keep reserves against them. Therefore, banks like to sweep (and create) as many of these deposits as possible into the savings categories. That’s why there is an upward bias to the underlying trend in the ratio of excess to total reserves. It does not reflect an increasing tendency for bankers to restrict lending voluntarily, but likely understates the inflation in reserves.

But while the figure on total reserves may have become obsolete and lost much of its relevance, big changes in the data are always important and shed light on things.

Today, the Fed is opening new windows through which to transmit policy. It can inject liquidity directly into money markets, and now commercial paper markets. It can lend directly to primary dealers. It can buy mortgages. It can pay interest on deposits, which will have two effects: exposing the hidden reserves (above) and luring money into the Fed. The latter is deflationary, but the interest payments are inflationary, if “unsterilized.” At every crisis that is bigger than the last, the deflation argument is always compelling. But it is fundamentally misguided if it is related to the idea of asset deflation or deleveraging. These concepts are not interchangeable with deflation.

Deflation, for instance, hasn’t occurred since 1933, but deleveraging and asset deflation have, often — last in the 2000-02 bear market, and even as the Fed and banking system created a bunch of money.

Banks don’t make money on the interest differential from lending out other people’s deposits. They make money by lending out more than they take in…by “creating” deposits (i.e., inflation).

This is what a fractional reserve banking system does. It will lend again once it is confident that the central bank is making funds easily available and stands ready to bail banks out. By not printing until last month and letting Lehman go, the Fed sent out mixed messages that it is only now clearing up.

Abolishing the Fed would be a great idea.

Your freedom would be secure. Recessions would be gone. Governments would not be able to increase spending without immediate retribution. Growth and equality would become synonymous.

Crazy?

Not really. It’s basic economics.

However, it appears somewhat utopian given the public’s attitudes about the market and politics.

Most of the world, led by its political leaders, believes that the economic crisis was caused by greed and excess in the private sector, that the market is inherently unstable or that deregulation was the culprit.

Even some Austrian School authors blame the repeal of Glass-Steagall — the New Deal-era legislation that prohibited bank holding companies from owning nonbank financial firms or competing with securities and insurance companies — for the crisis. That’s ironic for reasons I won’t get into here, but it is a qualified charge — meaning deregulation is a good idea only if the central bank didn’t exist. I personally don’t agree.

Still, people by and large do NOT see monetary and fiscal policy as interventions causing disequilibrium.

They see them as offsetting and stabilizing institutions — safety nets and tools of economic and social management — as they were supposedly envisioned.

For this reason, I posit, central banks and governments do not have the political will it takes to do nothing.

The change in Fed policy last month proves precisely that, which is why gold should soar.

I believe the markets are wrong again to perceive a deflationary outcome. It is an entirely different monetary system than existed in the 1930s, when the Fed could not simply print up reserves.

Deleveraging and asset deflation are not bearish for gold, as they don’t necessarily imply a contraction in money supply, and rarely have. They may be bearish for gold stocks, but they are bullish for gold prices, because they are the very factors that motivate the near-certain cries for new credit (or more money) arising from a bad understanding of the true causes of the crisis. They are not new and are ultimately dwarfed by the next crisis.

But maybe the deflationists will be right about the behavior of banks this time. They have been wrong at each point in history when the economy faced a crisis caused by inflation. The thymological (historical) experience is that when the Fed inflates, the banking system does soon after. The Fed has never inflated in one month as much as it did in September. So the odds are against deflationists.

Indeed, the money supply could grow 25-50% in less than a year if that liquidity isn’t taken back.

Ultimately, though, both the prior boom and the bust can be explained wholly by the Fed’s specific policies. As will the next boom…in gold mining!

Regards,
Ed Bugos

October 28, 2008

P.S.: I have a few very interesting ways to maximize the upside in the gold boom which we all know will resume.

Stumbling into a Bull Market was originally featured on Whiskey and Gunpowder

If the market says that oil is worth $147 one day and $100 the next, that does not mean the first number was wrong. Nor does it mean the second number is right for tomorrow. The value of a barrel of oil is whatever the market says it is.

The market exists to discover value.

If you could do it with a pen and paper, you would not need the market. Speculators merely try to anticipate changes in values — over time. And charts are like a window into their message, or story, if you will…they are not a crystal ball.

But before I look at any position, the first thing I do is look at the chart in order to determine what the market is telling me about an asset or commodity, the economy or even monetary policy…

Technical “Chalk Marks” Suggest Deflation as Fed Policy Outcome

Maybe it is early, but the chart says the Dow could be ripe for a break to new bear market lows. That should be bullish for gold if it prompts the central bank into action.

For the past year, declines in the stock market have spurred gold higher on just this expectation, as was the case back in the last Dow bear (2001-02). When that happens, it undermines the dollar — and confidence in the central bank’s policy, making it less effective. It limits the Fed’s ability to cope.

For this reason, the Federal Reserve had deliberately chosen not to expand the money supply, which had been growing in the low single digits (year-over-year percent) for over a year, despite implementing massive rate cuts. It was a deliberately “sterilized” policy — in Bernanke’s own words — aimed at lowering inflation expectations without undermining the boom. It was aimed at shedding his moniker, “Helicopter” Ben. That was a tough balancing act — impossible, probably — and he was bound to get it wrong.

Trouble is, the market was betting that the risk was to deflation.

That is, we saw asset and commodity prices under continued pressure and technically significant chart moves in the dollar and gold suggesting that the market is anticipating this policy to err on the side of deflation, rather than inflation…not that the Fed wants any errors. In fact, the dollar’s move this week potentially reversed a 3-year downtrend.

At least, the bearish trend is neutralized…even if the U.S. dollar index were to drop back to 72 now, we could not call it bearish until it put in a lower low; the bulls might just be setting up a double bottom. Our readers know that I have been looking for a bottom in the foreign exchange value of the dollar for almost a year now. I don’t know how these trends will work themselves out over the next three-six months, but the case could be made for a bear market rally in the U.S. dollar index that extends back to the 90-95 level over the next year or two, before we get to the final chapter in its demise as the reserve currency.

Don’t forget, with respect to the U.S. dollar index, we are talking about its value relative to other funny money. That’s why I have argued that gold would advance despite it. So far, it has not.

Although there is no deflation yet, those footprints suggest the market is starting to think about it.

There’s Good Reason to Disagree with the Market

I think the odds are very low that you will see deflation — outside of a short-term aberration. This is because banks can create money, and there is nothing restricting them from creating all they want.

There is no gold standard today.

Governments got rid of the gold standard so they could inflate without restriction.

Moreover, the central bank has only increased its control of the financial sector over the decades. If we ever had a real deflation (in the monetary aggregates), it would have to be deliberated. That is why the odds are low.

According to the True Money Supply, an Austrian School monetary aggregate, the Fed is currently no tighter than it was in the late ‘60s or mid-‘70s, or even 2000, for that matter.

It is not the 1980, 1990 or 1994 Fed, which was committed to disinflation — and had the public behind it. Nor is it as easy as Greenspan’s post-1996 or post-2001 Fed.

Still, the Fed’s policy could produce a deflation scare if it overshoots in its aim against expectations and allows some deflation in money and credit by some unforeseen accident…or moral hazard.

Such a scenario would probably make the chart right about $695, and boost the dollar.  And this could happen even if we are ultimately right about gold going to $3,000, or higher. It would be temporary, no doubt, Ben would quickly sport his helicopter hat in response.

But there is reason to doubt even a deflation scare.

I am skeptical that the Bernanke Fed will stick to its guns on the money supply for the following reasons:

1. The Fed’s current policy is already net bearish for the “boom” — That is, without money supply growth the “boom” will continue to falter.
2. The political mandate for a tight Fed is weak — In the current economic condition without a forced hand, the Fed will increase money supply.
3. The economy is in no shape for a tightening — At this point the economy is used to cheap money and a tightening of the money supply would cause a “bust” cycle.

However, as long as the Fed can bluff and withstand from increasing the money supply the gold chart will probably be right. If the bulls cannot hold the Aug. 15 low at about $774 on the front-month Comex contract or recover the $850 handle anytime soon, we’re going to $695, plus or minus, over the next few months.

This risk will dissipate if the bulls can recover $850, especially on a strong dollar. In fact, we have to look back only to 2005 for an example of this bullish scenario. I have already remarked on the similarities in this correction to 2004.

The 2004 correction in the gold sector was the one that occurred ahead of the Fed’s last tightening. Six months after the tightening started, the U.S. dollar began to advance. It advanced all year in 2005.

Likewise, I expect that the gold market will shrug off the deflation scare and recover soon here, as well, ultimately undermining the dollar advance. That is right: The U.S. dollar is the dependent variable, not gold.

It is correct to say that the U.S. dollar is gaining ground on the heels of gold’s correction; it is incorrect to say that gold is weak because the dollar is strong. Gold is weak because the Fed is targeting it.

But the Fed is bluffing with a bad hand.

Regards,
Ed Bugos
October 14, 2008

The Market Versus the Fed’s Money Supply was originally featured on Whiskey and Gunpowder

I know of two actual bear attacks since July — I guess that is not all that surprising in the Pacific Northwest. Just last week, my neighbor surprised one rummaging through my garbage in the middle of the night. On Wednesday, as I was driving back home from my usual 4:00 a.m. coffee at Starbucks, I too came face to face, or grill to bum, with a bear. It was neck deep in one of my neighbors’ garbage cans, which it had dragged half way onto the road in front of me.

It is going to be a long winter, I thought to myself, as I wondered why this big fellow wasn’t getting out of my way. Stubborn bastard. Big too. I flashed my high beams. Then anxiety began to grip me and I started worrying that it might mall my paint job if I made it mad, or even chase me into the driveway, which was just a few houses down. Should I call the police? Should I honk and wake the neighbors?

Stay cool, I reassured myself. I have raised dogs almost as big as this ole bear.

No sooner did I calm down then he moseyed on off the road, and I made my escape. Whew.

Is the Gold Bear Gone?

Talk about synchronicity, it occurred to me later that day, when we saw the gold market make its biggest one day reversal in nine years.

The bulls went straight through all manner of intermediate resistance to end up $84 at over $860 on the day, and then continued on Thursday to print a high of about $910 before the cash market settled back at around the $845 level going into the Friday morning session in Europe. Gold traded as low as $736 only one week earlier.

As in my bear confrontation before the market open, I was just beginning to think about accepting the possibility that the gold bear would not go away until next year when, suddenly, it made its exit. Or did it? Is this just another false start? A sharp bear market rally? The answer is important to your investment strategy. Stay tuned.

What Has Changed in One Week?

The ink had hardly dried on the U.S. Treasury’s socialization of Fannie and Freddie, and thus half of the U.S. mortgage market, when it realized it would have to reconvene over whether Lehman was too big to fail the following weekend. Apparently, it was not, and so began the filing of the largest bankruptcy in U.S. history.

Then the dominoes really began to fall. Merrill Lynch was taken out, and then speculation turned on AIG, Goldman, Morgan Stanley and many others. The Treasury ended up taking control of AIG, but not before giving rise to fears about the exposure of “safe” assets, like money market funds, to Lehman or AIG or whatever failing counterparty might be guaranteeing this or that in your portfolio.

The events reminded investors that there is nowhere to hide, except, perhaps, in the one asset that is “no one else’s liability” — gold. The government is grabbing at straws. The Federal Reserve’s balance sheet is wearing so thin that the Treasury is raising money for it on Wall Street now. Talk about wash trades. It is not just the U.S. markets. Loan markets are stressed all over the world. Russian markets froze this week too. The Chinese central bank cut rates and its government kicked off a plan to start buying stocks for its sovereign wealth fund to stem the bearish tide.

Despite fluctuations in expectations, the fundamentals have remained bullish for gold. The events have generally confirmed gold bulls’ warnings, and all but guarantee future inflation.

Evidence of soaring demand in the physical space has been oft reported throughout the correction.

The amount of contracts closed on futures exchanges dwarfs the real ounces liquidated by the bullion trusts in this time. On the COMEX alone the amount of contracts outstanding shrank by 10 million oz, compared with just two million ounces for the streetTracks GLD bullion trust.

Stay the Course

This move in gold does not look like a bear market rally. It looks real. In fact, it suggests that the decline through $850 last month was a mistake…that the market was wrong, as we suspected. That is, the market was wrong to think the bust was over, that central banks were capable of any kind of “tightening” or that the problems for the dollar have passed.

My general suggestion is to buy the dips and corrections. Don’t chase the breakouts. The reason is that it is not yet a slam-dunk that the Fed will inflate. We have to adopt a wait-and-see attitude.

Regards,
Ed Bugos
September 24, 2008

The End of Gold’s Bear Market was originally featured on Whiskey and Gunpowder

In English, please? The bulls got suckered.

Gold prices fell through their $850 May low now, which means that I was wrong to think that the market had discounted a reversal in oil and the dollar, both of which we fully expected.

But could the market be setting up the bears here?

The last time that we saw two false signals in a row was in 2004, when a marginal new high reversed sharply and turned down to break a key support level, trapping the bears before turning up for good. Interestingly, this happened when Greenspan started his tightening campaign.

It is significant that he didn’t have to deal with a financial and economic crisis, and that his gradual rate increases didn’t do anything to gold, anyway — though they were enough to derail the housing boom.

Today’s Fed is constrained from even a small tightening by the condition of the economy.

Of course, we’ve already had two false signals in the chart, so if this is a bear trap it’ll be the third, which would make it different than in 2004, or at any other juncture in this bull so far.

The gold stock charts tell a more bearish story.

Now, you must keep in mind that while deceptive moves have been rare in gold itself over the course of this bull market, bear traps have been common in the gold share averages — especially the Amex Gold Bugs Index below. For the record, a bear trap is a move, like a breakdown, that suckers the shorts; a bull trap is a move that suckers the bulls:

A bear trap has occurred as a false breakdown in the chart on at least three noticeably separate occasions — 2001, 2005 and 2007. In each case, a bullish move followed immediately. I don’t know if history will repeat itself, but the record says breakdowns in the HUI are a buy.

For the Love of Gold

I keep telling you, gold is next! No one believes it yet. Who can blame them?

We all would have done better owning oil stocks, at least after 2004. In fact, you would think the only reason gold ever went up is because of oil. But you’ll find some truth in every lie.

Undoubtedly, energy is vitally important to the economic engine of growth.

It’s used in every imaginable process. Oil is important only because it is the most convenient source of this energy, but tomorrow, it might be something else that does this job. Gold, of course, is jewelry. It’s not technically money, except in select circles. But I want to draw your attention to the need for money…it is just as vital to the economic engine as energy.

Given the record of fiat money, invariably the debate will shift to the best kind of money in the same way that it currently revolves around the best kind of energy.

So what would it take to see the same love in gold that we saw in tech stocks in 1999, the housing market in 2003-05 or oil recently? The answer is simple: More of the same…

You will see it in gold when all the usual anti-gold arguments fall flat on their faces… when people no longer believe that the “modern-day” central bank has a handle on inflation and interest rates; that inflation is “caused” by oil, growth or a shortage of goods; or that prices will one day come down.

You will see it when people realize that the bubble in commodities is really a destruction of confidence in the medium of exchange. Yes, this can get overdone, like anything else in the market. But unlike a specific bubble, it will repeat itself generally, against some other asset, commodity or maybe all goods.

Why?

Simply because the central bank and government are afraid to address the root cause.

All that the central banks have to do is abandon the boom by letting the market determine the proper interest rate level. This is the only lasting solution to the current inflationary quagmire.

They won’t do it. The short-term costs are too high, and rise with each new asset bubble.

No, the bull market in gold is not over.

The best is yet to come.

Top 10 Reasons to End Cheap Gold

I can understand why investors are selling their large-cap gold stocks. They aren’t making any money — at $900 gold! And they’re trading at 20-50 times earnings. Still, while the rising cost of producing gold is trouble for gold stocks, it is also one of the most bullish factors underpinning gold values.

Effectively, $700 gold would be as catastrophic for the industry today as $300 gold was in 1999.

With jewelry demand alone, the supply side is already tighter than it is in oil.

As I went through my 18-point model, I was looking for reasons to buy gold that have not been widely discounted, aside from the big one above — i.e., in which the masses wake up and fall in love with gold:

• Cost inflation slowing down development pipeline, hence future production growth
• Political risks in frontier countries also shrinking available supplies
• Faltering global economy persuading central bankers to abandon tightening plans
• Soaring government deficits
• Saber rattling between Iran and Israel and other geopolitical tensions heating up
• Another GLD ETF just listed on Hong Kong Exchange
• Some countries already experiencing crackup and heightened gold demand
• Shrinking official gold supply
• Seasonal trends turning bullish again into the new year
• Large producer Anglo has yet to cover all its hedges.

Regards,
Ed Bugos
September 2, 2008

The Gold Market was originally featured on Whiskey and Gunpowder

But before I tell you what it is, I want to give you a sense of how big this really is: It’s exactly like being there for the birth of the offshore oil and gas industry.

This industry, born of the 1970s energy crisis, now produces about a third of the world’s oil output. But back in the ‘40s and ‘50s, it was still a frontier…a pipe dream, to many.

Geologists today know of some 115 billion barrels of oil and 633 trillion cubic feet of natural gas reserves in the Outer Continental Shelf surrounding America’s coastlines alone. There are some 450 operating platforms in the North Sea today, and several thousands in the Gulf of Mexico. It is a trillion-dollar-per-year industry, plus or minus.

Thanks to the mother of inventions, offshore drillers have overcome many obstacles (mostly political). And in the process, they have unwittingly laid the technical and legal groundwork for a whole new industry…

Until recently, offshore drilling had gotten a bad rap from both political parties. The ban on drilling was first made by George H.W. Bush and has stood until his son recently proposed repealing the ban.

Both candidates in the upcoming presidential election had been opposed to offshore drilling but have changed their stances in the recent weeks. Republican John McCain has stood by the president and called for an increase in offshore drilling. McCain attempted to drive yet another wedge between himself and his democratic rival.

But even Democratic Sen. Barack Obama has eased off his stance against drilling. Obama stated last week that he would support offshore drilling as part of a comprehensive energy plan. It seems that both sides of the aisle have felt the pressure of rising fuel prices. The winner in these new political concessions will clearly be the offshore drillers themselves.

So while the toughest obstacle is finally cleared for drillers, there could be a flood of opportunities made for investors.

There is one company I’m looking at. It is this industry’s leader. Its founder led the group that co-discovered the 40 million ounce Lihir gold mine in Papua New Guinea (put into production during the late ‘90s). He is still a founding director of Lihir Gold and a fellow of the Australasian Institute of Mining and Metallurgy. He surrounds himself with old mining hands, including former Placer Dome and BHP executives.

I bet you’ve already figured out that we’re talking about a mineral deposit.

What’s so new about that, right?

Get this: It’s under the sea. Yes, we are about to see the first major startup in the deep-sea mining industry. If it’s anything like the boom in offshore drilling, you’ll want to be there.

The world’s largest gold companies together own over one-third of this company.

These players are so bullish on the prospects of this industry they all entered into non-competing and anti-dilution clauses just to get a tiny foothold… Teck Cominco and Anglo American have paid millions of dollars for a mere option to participate in a potential future joint venture. And millions more in direct investments.

Anglo and Teck’s investments total more than $50 million.

Placer Dome alone spent more than $13 million earning a joint venture interest with this company.

And in 2006, shortly after Barrick took Placer Dome over, it decided to convert Placer’s JV interests into a 9.6% equity interest (which has since diluted to less than 5%) at a deemed price of $2.86 per share.

But wait, you may wonder, just how new is this?

Outside of a few dredging operations for diamonds off the African coast in recent years, the extraction of minerals from the seafloor is virtually untapped. No one has mined the seafloor, though geologists have long known of its potential…

For a long while, they thought that these minerals were deposited as sediments from eroding deposits on nearby land. But it was later realized that the source of massive sulfides on land was the ocean, and that hydrothermal events beneath the ocean seafloor precipitated into a mineral deposit upon contact with the water. In fact, in 1985, seafloor massive sulfide systems were discovered off the coast of Papua New Guinea by a research vessel at a site claimed by our company.

Given a few modifications to technology produced by the offshore oil industry over the last few decades, the outcome of a new international treaty on deep-sea mining in the ‘90s, advances made by our company toward the establishment of the first-ever deep-sea mine this decade and the growing worldwide demand for scarce mineral resources, the time is right for this industry to emerge…and the deep sea mining profits should follow!

Regards,
Ed Bugos
August 13, 2008

P.S.: Advances in the offshore oil industry have aided operations for deep-sea miners. But these technological and political advances aren’t the only factors aiding the mineral mining industries. There are several economic reasons why mining stocks are set to soar. Readers of my Gold & Options Trader service already know this.

Deep-Sea Mining was originally featured on Whiskey and Gunpowder

The Dow gave back almost five days’ worth of gains in one fell swoop.

So should we not have seen a better bounce in gold? Maybe it’s too early to call the Dow.

Further weighing on gold prices were a lifeless bounce in oil and the market’s shift in focus to signs that gas demand is ebbing. Sometimes, however, there is a delayed reaction in gold, which happens more often than efficient market theorists would like to admit. Gold’s fundamentals are still bullish.

Mining costs continue to increase, which pushes up the floor on gold prices.

Several months ago, I calculated that production costs had more than doubled for the gold mining industry since gold traded at under $300 per ounce some eight years ago, and, consequently, that the decision to shut down mines would today occur at $600-700, rather than $300. The supply situation is already tight. It is getting increasingly difficult to replace gold reserves. And of course, there is no end in sight to the readiness of central bankers to inflate, guaranteeing a strong flow of gold demand.

As for the prognosis, I see two possible scenarios for which there is some technical precedent.

Technically, the market is trendless. Neither bulls nor bears have gained much traction since the correction began in March. The seasonal low could be in, but it remains unconfirmed by a higher high.

A casual glance at the chart would tell you nothing except that the market could fall to $750 as easily as it could rally to $1,200. Technicians would call it a neutral pattern, though some may read bullish or bearish biases into how it is developing. I won’t get into that. But one does not have to be a technical analyst in order to grasp some useful truths from the chart.

It is true that history never exactly repeats itself. But there are similarities, or regularity in the behavior of prices, that can help with our outlook.

For example, if you look at the corrections since 2001 in the chart below, you’ll notice that rarely have they lasted much more than a couple of quarters before the bulls took charge again. You might also notice that the first leg in each correction has been followed by a second one that usually fails to make a lower low — 2004 being the exception. The market also likes to brush up against its 50-week moving average before completing the correction.

Moreover, we can even infer a loose relation between the extent of a rally and the depth and duration of the ensuing correction. These things are called “technical” mainly because they have nothing to do with the fundamentals. And let me tell you, it is dangerous to put too much weight on past performance and behaviors when we’re talking about investors and the market.

Notwithstanding, if this were just a typical correction, we could expect to see a second “attempt” by the bears to make a lower low over the next month or two before the bulls break out, sometime in the fall.

But the exception is worth considering, too.

Give The Gold Rally Some Elbowroom!

The market is at an important number and inflection point, which threatens to complicate the situation central bankers face today — their control of interest rates, to be precise.

Naturally, the “powers” will do everything they can to resist this change.

Similar conditions prevailed back in 2004, when gold was trying to break past its old 1996 high, about $425ish, which would reverse the downtrend in the longer-term charts and signal a new bull market — note in the chart below how the moves became more violent once gold broke past this level.

As it is now, the Fed was then about to embark on its tightening campaign, after having talked about it for almost a year… making gold bulls nervous about the impact of higher rates. Of course, the Fed’s job was a tad easier then. There was no series of financial crises to contend with. The stock market hiccupped, but the economy was producing jobs, and nobody much minded the Fed gradually ratcheting up interest rates.

As it turned out, however, it was just enough to keep bondholders happy, but not enough to rein in the effects of the Fed’s previous inflation policy. The bears pushed down on gold prices, but did not realize just how tight the springs were and got caught in a lower chart low before gold whipsawed higher.

The market hasn’t looked back since.

So it is possible that the market could make a lower low, if only to make more elbowroom in the chart for the breakout… sort of like pulling a slingshot back further to get a little more energy out of it.

On the other hand, the Fed’s hand is weaker than it was in 2004-05. Because of this, I have to favor the former scenario, in which the correction low in gold is already in.

Regards,
Ed Bugos
July 29, 2008

P.S.: While we wait for the gold correction phase to end, and the next phase of the gold rally to begin, investors are facing a great opportunity for investment. As you just read, the technical and fundamentals point to the price of gold going up once again. This is the price dip you’ve been waiting for, and now you can really begin making some money in the coming blowoff phase.

The Gold Correction was originally featured on Whiskey and Gunpowder

He did that to get your attention.

Fed chairs rarely ever say that word, for reasons that Greenspan learned on his first days in office back in 1987 — the same reasons that CEOs rarely comment on their stock’s valuation.

Bernanke’s original remarks came before Friday’s unemployment report rained on Wall Street.

But just in case anyone thought the weak report might have softened his stance over the weekend, on Monday, he repeated his determination to tackle increases in long-term inflation expectations, and to fix the dollar. The rhetoric helped boost the currency and splashed cold water on gold’s recovery.

I say “helped” because the Saudis did most of the work by announcing an output hike (500,000 bpd).

Let me tell you right out of the gate that, as a rule, the Fed talks tougher than it is capable of acting, especially with a new administration around the corner. Bernanke has nothing more in mind than taking away the interest rate stimulus, as Greenspan did after 2004 — gradually and marginally…if that!

What’s more, the consensus doesn’t expect any action near term. Even more crucially, ultimately, his resolve rests on the correctness of his premise that the risks to economic growth have abated.

The Fed is not ideologically equipped to tackle the duality of rising unemployment and rising prices. Do you really think it is going to hike rates while stocks are reeling?

No. It just assumes that won’t be happening at the same time that prices are generally still rising.

But what is most important to understand is the factor that stirred the hawkish rejoinder.

For it is obvious that the Fed is reacting to market sentiments. And those sentiments are what I want to bring to your attention.

Is This the Crackup?

Back in March, oil prices were just breaking through $100, and the Fed hinted that it was probably finished cutting interest rates. Investors started looking for a big commodity and oil price correction.

It wasn’t to be.

Oil continued charging higher, egged on by bullish calls from America’s biggest investment dealers.

It is now backing off a high of about $139 in the nearest futures contract. That’s up 40 percent in three months, 100 percent in 12 months and nearly 200 percent in fewer than two years. It’s up more than 1,000 percent over the past 10 years. The moves in crude have been nothing short of spectacular.

On May 21, when the front month was breaking through $130, I got a call from a friend of mine — an oil analyst who runs his own investment service out of New Jersey. Like me, he’s been bullish since the turn of the millennium, but neither of us expected anything like this. Is this the crackup, he asked?

That’s the first time someone asked me if this was it…you know, “it.”

The crackup is a stage of the inflationary boom that occurs late in the cycle — when the market gets the idea that money grows on trees…and it finally abandons the idea that “prices will one day drop.”

Fear marks this final stage — in particular, of the erosion in monetary values.

It is born of a revelation, according to its author: “Finally, the masses wake up” to the fact that “inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crackup boom appears.”

However, it is the final stage of the boom. It is relatively short. It could last days, weeks, maybe even months, but the author (Mises) did not have much more in mind than that.

It is literally the death of that particular money.

Importantly, Ludwig von Mises concludes, “If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds.”

The laws of supply and demand determine money’s value, as with anything else. And if the supply of something is unlimited, it’s not usually worth much. So the Fed likes to downplay the fact that it can or will print money “beyond all bounds.”

I doubt we are seeing the crackup.

But we are seeing some of the things that characterize the onset of the late stages of a long-in-the-tooth inflationary cycle — in which prices rise because people expect them to rise, and the demand for money drops as confidence in the economy and the world’s common medium of exchange erodes.

As Market Focus Shifts to Money Relation…

Bernanke senses that the market is making a dangerous transition.

If I could point to one catalyst, it would be that the commodity markets are making moves that make the situation difficult to explain in terms of regular supply-and-demand fundamentals. That is, people are finally asking questions like how could the total demand for oil have doubled in just 12 months?

As Dr. Benn Steil, an economist at the Council on Foreign Relations, on May 20 stated:

“If you want to explain this terrifying apparent shortage of food that we now have in the world, I don’t think you could possibly explain it based upon enormous growth in the world’s appetite for food over the past three quarters. It just can’t be done.”

Indeed, although it was completely unrelated to this speech, the question of crack-up came the day after Steil’s speech to the Committee on Homeland Security, in which he pinned the commodity bull market almost entirely on fiat money inflation, and drew attention to gold’s relative stability as money:

“Whereas the prices of oil and wheat measured in dollars have soared over the course of this decade, they have, on the other hand, been remarkably stable when measured in terms of gold — gold having been the foundation of the world’s monetary system until 1971. It is, therefore, reasonable to conclude not that we are  experiencing a commodities bubble, but, rather, the end of what might usefully be termed a ‘currency bubble.’”

George Soros’ subsequent comments last week regarding doubts about the dollar’s reserve status were like a beacon to the Fed. Undoubtedly, they provoked Bernanke’s rebuttal. For they reflect sentiments the Fed would rather discourage, as they are difficult to “control.”

For the past eight years, the big money has explained the commodity bull market in terms of events like Sept. 11, growth in Asia and other developing frontiers, previous underinvestment or the finiteness of commodities. The Fed has succeeded in discouraging the market from pointing its invisible finger at it.

But the commodity bull market is about to take on a whole new form…

Regards,
Ed Bugos
June 18, 2008

P.S.: With gold still readying itself for another historic run, there has never been a better time to begin investing in the miners that bring this gold to market. Readers of my Gold & Options Trader service have already heard the word on a new miner that has a new take on the process of mining itself.

Inflation and Commodity Prices was originally featured on Whiskey and Gunpowder