Putting even more on…

Just a brief post to inform our readers that we’re adding to our silver holdings. We saw a decent washout on the 1st of March that might have marked the low. Even if it turns out that it hasn’t, sentiment and positioning (plus strong support in the 27.50$/oz. area) have us thinking that the downside is limited.
We also want to mention en passant that today’s action in miners looks promising: a nice reversal on large volume. Given how oversold they are, this strikes us as a good entry point. We do however remain convinced that outright ownership of precious metals is the way to go in this (and every other) bull market: mining companies may act as leveraged proxies from time to time (and this is likely one of those), but they can’t offer the safety and returns of the actual physical stuff.
As usual, do your own research.

“You know, it’s a Bull Market!”

The wise words of old Mr. Partridge undoubtedly apply today to both Gold and Silver and the objective of this post is to outline the main fundamental reasons that determine the metals’ long-term bullish trend. We will also provide a brief overview of the current technical/sentiment situation, which is in our opinion neutral to slightly positive. We’ll focus mainly on gold, but much of what we’ll say applies to silver as well, with the important caveat that the poor man’s gold is much more volatile than the yellow metal and its performance is more strictly dependent on the ebb and flow of speculative demand.

Before starting, however, we have to ask an important question: is gold money? The answer is yes and no. Yes, because it possesses certain characteristics that make it fit for the role of money, the very same characteristics that prompted its use as a medium of exchange in ancient times (see Carl Menger’s seminal work on the origins of money). These features cannot be stripped away from gold by means of government decree: it will continue to hold them and people will continue to be attracted to them whenever and wherever the need for sound money will arise. No, because money is correctly defined as “the general medium of exchange, the thing that all other goods and services are traded for, the final payment for such goods and services on the market (Rothbard, Austrian Definitions of the Supply of Money)”. Clearly, you can’t pay for petrol with a nice gold bling-bling (unless maybe you happen to be a gangsta rapper). We must therefore keep the above in mind when analysing gold and the determinants of its price. We may sum the above concepts up by saying that gold is a commodity until it isn’t.

A final note on the usage of some words: when talking about gold we’ll use the terms money or the money commodity, whilst when referring to the fancily coloured pieces of nothing that we all keep in our wallets we’ll use the terms paper money or fiat money.

The Fundamental Backdrop

A) A brief introduction to the Austrian Theory of Money

As hard-core Rothbardians, we are of course biased in our assessment, but let us tell you: the Austrian Theory of Money kicks ass! Well, at least in the realm of economics…

In this field, the main achievement of the Austrian School (hat tip to Ludwig Von Mises) has been the successful application of Marginal Utility Theory to the analysis of money, its demand and its value. This has allowed the Austrian School to treat money like all other goods (even though it clearly recognizes money’s peculiar function and its specific characteristics) and thus offer a comprehensive and coherent body of economic theory based on the laws of praxeology and the action axiom. As Murray Rothbard so aptly put it: “No longer did the theory of money need to be separated from the general economic theory of individual action and utility, of supply, demand, and price; no longer did monetary theory have to suffer isolation in a context of "velocities of circulation, " "price levels," and "equations of exchange".”

The supply and demand relationship can thus be represented graphically in the usual fashion (total demand-stock analysis): a falling demand curve intersects at a certain equilibrium point (where supply and demand meet) a vertical line which represents the total stock of money at the given time. On the horizontal axis we find the quantity of money (its supply), increasing rightwards, and on the vertical axis its price (in this case the purchasing power of money or PPM), increasing upwards:

We can’t refrain here from singling out the economic ignoramus Antal Fekete, founder of the “New Austrian School”, and his equally ignorant disciples, who claim that money doesn’t have declining marginal utility (or if it has it, its rate of decline is “negligible”): this is hogwash and we wonder how come they still use the adjective “Austrian” when they reject one of the core tenets of the Austrian School and thoroughly ignore one Mises’s most important contributions to economic theory. Not really surprising: after all they’re a bunch of monetary cranks and their ignorance certainly does not limit itself to the above.

B) Supply of and Demand for Money and their determinants

1) The Supply of Money

The supply of the money commodity tends to grow steadily and modestly over time: each year mining adds a small percentage to the total stock, whilst non-monetary uses and wear and tear reduce it. Fiat money on the other end is conjured into existence by the Central Bank and the Banking Cartel, either via outright money printing or via the more subtle process known as fractional reserve lending. They can increase its supply at will and, since the process allows the early recipients (the banks themselves, big business and the the well-off) to gain at the expense of the late recipients (workers, pensioners etc.), they are likely to do so.

It is obvious from the graph above that ceteris paribus an increase in the supply of money will determine a decrease in its purchasing power and vice versa.

2) The demand for Money

The demand for money has three subcomponents.

A) Non-monetary demand

This is the demand to use the money commodity for purposes other than monetary exchange (e.g. the use of gold in electronic circuits). If gold were actually used as everyday money, this demand would very likely be lower than it currently is, as the opportunity cost of using the metal would probably increase sharply. In any case, even now, as the price of gold increases, non-monetary demand tends to decrease, as the opportunity cost rises. Silver is much more dependent than gold on the vagaries of such demand.

Obviously non-monetary demand is nonexistent in the case of fiat money (apart from tragicomic situations: e.g. people in Weimar burnt marks in the stove as they were cheaper than wood).

B) Exchange demand for Money

This is the demand to acquire money for exchange purposes by sellers of other goods and labour: people sell their surplus in order to obtain money with which to engage in indirect exchange (thus avoiding the limits of direct exchange, a.k.a barter). Sellers of goods will tend to have a perfectly inelastic demand curve (as they have no reservation use for their goods), whilst sellers of labour will have a falling demand curve (since they could always trade work for leisure): the combined exchange-demand curve for money is thus falling (as the PPM increases, the exchange demand for money falls). It’s clear that in the current situation, this demand is almost nonexistent for gold (nobody asks to be paid in gold for his work). It is however an important determinant of the value of fiat money, given that this demand exists only as long as paper money is the accepted medium of exchange.

C) Reservation demand for Money

The third subcomponent is the most volatile and thus most important one: it is the demand to hold money by people who have already acquired it. Money acquired on the market (by selling goods or labour) can be spent, either on consumption goods or investment goods, or added to one’s cash balance. Money already in the cash balance can either be kept there or dishoarded (i.e. spent on consumption or investment goods).

Ceteris paribus an increase in the PPM will result in a reduction in reservation demand (as the value of money in terms of other goods increases, a lower quantity of money can now perform the same functions earlier performed by a greater quantity) and vice versa. There is an extremely important exception to this rule and that is when the Misesian crack-up boom appears: as people become aware of the deliberateness of the inflationary policy, their reservation demand to hold paper money falls dramatically as the money supply increases, thus exacerbating the inflationary crisis (see also further below). This of course can’t happen to gold, unless we were to really find the philosopher’s stone.

We will see below what could alter people’s decisions to hoard or dishoard money (i.e. what could cause a shift of the reservation demand curve, as opposed to a simple movement up or down the current demand curve as in the example above), but it’s important to note that the values of both the money commodity and fiat money are heavily influenced by such shifts in demand.

3) Influences on the reservation demand for Money

All people familiar with praxeology know that it is of course impossible to formulate a law that precisely and quantifiably predicts how economic actors will react to given changes in the surrounding reality, as each man has his own scale of values and preferences and is constrained by his own set of circumstances. The deluded refusal to acknowledge this simple fact of life is also know as “Mathematical Economics” or “Econometrics” and has so far only managed to produce untold misery, by way of justifying idiotic interventionist policies with fancy “scientific” formulae.

It is however possible to infer certain general “rules of thumb” that can help us in making qualitative assessments on a certain situation. With that in mind, let’s see what can have a meaningful influence on people’s reservation demand for money and, as a consequence, on the value of money itself.

A) Uncertainty

Life is uncertain. We do not know what the future holds. But what if we were suddenly catapulted in a world of certainty, in an Evenly Rotating Economy (ERE) where equilibrium has been reached and nothing can possibly change (i.e. all prices are final prices and remain constant, production and consumption patterns repeat over and over again etc.)? What would happen to money in such a case? We’ll let Rothbard answer these questions:

“It is true, as we have said, that the only use for money is in exchange. From this, however, it must not be inferred, as some writers have done, that this exchange must be immediate. Indeed, the reason that a reservation demand for money exists and cash balances are kept is that the individual is keeping his money in reserve for future exchanges. That is the function of a cash bal­ance—to wait for a propitious time to make an exchange.

Suppose the ERE has been established. In such a world of certainty, there would be no risk of loss in investment and no need to keep cash balances on hand in case an emergency for consumer spending should arise. Everyone would therefore al­locate his money stock fully, to the purchase of either present goods or future goods, in accordance with his time preferences. No one would keep his money idle in a cash balance. Knowing that he will want to spend a certain amount of money on con­sumption in six months’ time, a man will lend his money out for that period to be returned at precisely the time it is to be spent. But if no one is willing to keep a cash balance longer than instantaneously, there will be no money held and no use for a money stock. Money, in short, would either be useless or very nearly so in the world of certainty.” (Rothbard, Man, Economy, State with Power and Markets, Chapter 11)

Luckily though we do not live such a dull existence, but a more spicy one. And, as Rothbard says:

“In the real world of uncertainty, as contrasted to the ERE, even “idle” money kept in a cash balance performs a use for its owner. Indeed, if it did not perform such a use, it would not be kept in his cash balance. Its uses are based precisely on the fact that the individual is not certain on what he will spend his money or of the precise time that he will spend it in the future.” (Rothbard, Ibid.)

It is therefore clear that uncertainty plays an important role in determining people’s reservation demand for money. It is safe to say that, ceteris paribus, an increase in uncertainty will most likely cause an increase in the reservation demand for money. This is intuitive: what do you do when you are faced with an economic emergency (e.g. you lose your job or your business fails, or you are faced with a large unexpected expense)? The most likely answer is: you raise cash, that is you either restrain your consumption or you sell your investments or a combination of both. The same holds true when such an unforeseen event affects all or the vast majority of people (e.g. an economic crisis, a bear market, a war, acts of god etc.): in the face of growing uncertainty people generally choose to increase their cash balances (i.e. their reservation demand curve shifts to the right).

Now we guess we don’t have to tell you what might go wrong in a world where increasing state intervention in the economy, endless money printing, gigantic malinvestments and growing social unrest rule the day…

B) Speculation

This is an easy point to make: if people expect the value of money to increase in the future, they’ll increase their hoarding now (i.e. their reservation demand will shift to the right), thus bringing about the change in the PPM in the present. Of course the opposite is true as well: “an expected future fall in the PPM will tend to lower the PPM now.” (Rothbard, Ibid.)

This is what has recently happened to the Yen: speculators anticipating massive devaluation of the currency by the BoJ rushed to sell it, thus causing the fall to occur in the present. Unfortunately for them, all the relevant data point to a rather serious misunderstanding of the BoJ’s real intentions on the part of the speculators. But no worries: erroneous speculations are self-correcting, not self-fulfilling as the minions of the State would like us to believe. Correct speculations, on the other hand, are beneficial as they speed up the market’s adjustment to the new equilibrium conditions.

In the case of gold, it is not difficult to see what could happen should a renewed economic crisis wreck havoc à la 2008/2009 on U.S. government finances at a time when debt and deficit monetization by the Fed and foreign central banks is already rampant, both in absolute and relative terms:

 

 

YoY Percentage Change in U.S. government Receipts and Outlays superimposed to a 12-month rolling measure of the Deficit. Chart via Michael Pollaro. Could that nasty divergence happen again? Of course it can: we only need a nice crisis! Problem is, the deficit’s current level is already way higher than in 2007, both in absolute and relative terms.

 

The result of the U.S. government profligacy is a record-high level of debt monetization on the part of both the Fed and foreign central banks. Guess how they finance their purchases?! And what if they have to buy even more, due to resurgence of the 2008/2009 dynamics outlined in the chart above?! Again, thanks to Michael Pollaro!

 

In the case of the dollar it’s certainly more difficult to foretell what the market’s reaction to such a situation might be, as people’s reservation demand to hold it ultimately rests on a precarious foundation, as Mises pointed out in Human Action:

“The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services, as has been shown, at different dates and to a different extent. This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them. It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796 and with the German Mark in 1923. It will happen again whenever the same conditions appear. 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. Inflation is a policy that cannot last forever.”

As such we can by no means know in advance whether the next crisis and the official response to it, likely constituting of a large dose of new inflation, are going to determine a shift in people’s perceptions dramatic enough to seal the fate of the dollar. In fact, we tend to doubt it. What we are strongly convinced of is that although the dollar could very well gain in value against other currencies, it is unlikely to make much progress, if any, in terms of gold.

4) A real-life example: the panic of 2008

Now that we have described the components of the demand for money and their main determinants, let’s see if we can manage to explain, using these instruments, what happened to both gold and the dollar in 2008.

Between July and November of 2008 the value of the dollar increased more than 20%, whilst the price of gold plummeted more than 30%.

The reservation demand for the dollar was clearly pushed to the right by both uncertainty and speculation that deflation would increase its PPM.

The case of gold is a bit more complex, as there were opposing forces at work: on the one hand, its price declined as speculators bet on a deflationary outcome; on the other hand, uncertainty pushed many people into the market (as demonstrated by the record surge in GLD holdings at the height of the panic, between September and October, which not accidentally coincided with Lehman’s bankruptcy). Once the deflationary scenario proved to be incorrect, its price soon returned to equilibrium: gold was by far the fastest asset to regain its pre-panic value and by February 2009 it was already close to it previous all-time high. It’s also important to note that during the panic it did either gain substantially or lose modestly against other currencies (with the exception of the Yen) and it also increased its PPM when measured against other goods (like e.g. crude oil, copper, equities etc.). Even if the deflationary outcome had come to pass, we suspect that gold would have not continued to lose value against the dollar, but its price would have most likely stabilized or even increased, as uncertainty would have become even greater as the financial system would have rightfully collapsed, thus pushing more and more people in the gold market at a time when sellers would have probably been rare (in fact the “Lehman demand” did indeed generate a meaningful rally in the price of gold). In any case it would have most certainly gained immensely in real terms (i.e. when measured against other goods, like houses, cars, food, energy etc.).

We can then conclude that both gold and the dollar benefited from an increase in people’s reservation demand for money, with the former temporarily succumbing to speculative forces (which subsequently self-corrected) and the latter of course profiting from its status as reserve currency (as well as the deflationary scare).

When the next crisis strikes, we fully expect gold to experience an even greater increase in reservation demand, as uncertainty will again increase and probably quite dramatically, given how unquestioningly people have put their faith in central bankers and their monetary tricks. Should (when, actually) the modern-day heirs of Count Cagliostro fail in bringing about prosperity by means of inflation, what would the poor saps do? Buy gold, that is. Moreover speculative forces should now be firmly on the same side, as it’s apparent that the default response to every problem is to “paper it over”.

C) Popular fallacies regarding Gold and its Bull Market

In light of the above, we can now embark on debunking some popular fallacies about gold and what drives its bull market.

1) Gold is a commodity

Although, as we have seen above, gold is not entirely money at this point in time, it is erroneous to then assume that it’s just your average commodity: it isn’t. And it follows that it’s dangerously misleading to apply conventional commodity-style studies to the gold market. Firstly, the existing stock dwarfs annual production, thus rendering traditional supply-side arguments useless (unless one correctly recognizes that the supply of gold is indeed its existing stock and not the annual mining output); secondly, as we have outlined before, there exists a reservation demand to hold gold, which is almost nonexistent in the case of other commodities (i.e. we have yet to meet sugar bugs or coffee hoarders) and which upsets standard demand-driven analysis that focuses just on those who want to acquire gold (without considering the far more important influence of those who already own it and want to keep it). This is always true, but becomes even truer when gold is, as is the case now, in a secular bull market, because it is at this precise time that gold takes on its monetary role with far more authoritativeness than before.

2) Indian demand and Chinese demand

The misconception that Indian or Chinese buying is an important force behind this bull market is the offshoot of the above “Gold is a commodity” fallacy. The reality is that there is more than enough gold available to meet both Indian and Chinese demand and the price at which it will do so depends not so much on the size of such demand as on the reservation demand of those who hold it (and have to sell it to the Indian or Chinese buyers). This is no surprise for those who understand that price is set at the margin.

Sceptical readers might want to peruse the data published by the World Gold Council and see whether they can find any significant correlation that lasts over the years between the vagaries of Indian and/or Chinese demand (or even global demand for that matter) and the gold price.

D) Miners ≠ Gold

That mining companies are different from gold is a truism. From this it should logically follow that the reasons to buy (or hold) gold are unlikely to also constitute valid reasons for buying mining companies. And yet many people view an investment in said companies as a way to somehow “leverage” their exposure to gold’s gains: the sad reality is that more often than not they only manage to leverage gold losses, while underperforming its gains. Sure, miners can and often indeed do rise together with gold, sometimes even exceeding its advance, but the reality is that people buy and hold gold to satisfy very specific needs that can’t be fulfilled by owning miners and the stronger these needs grow, the larger the discount at which mining companies trade relative to gold is bound to be. And this does not even begin to address all the myriad specific risks and pitfalls that mining companies present to investors…

Readers wanting factual proof of this need to look no further than the last big gold bull market of the ‘70s: at their respective peaks at the beginning of 1980, both gold and silver had outperformed the miners (as represented by the Barron’s Gold Mining Index) by a wide margin (gold returned almost 4 times more than the BGMI and silver almost 6 times more). Once the bull market ended (and so did the particular reasons to own precious metals) miners did skyrocket higher, doubling in less than a year an peaking in October 1980, as their profit margins were indeed being boosted by still very high gold prices (and yet their total return for the bull was still less than half that of both gold and silver).

Of course peddlers of mining stocks or of investment newsletters of questionable quality will point out to some specific miners which indeed saw returns higher than the metals, but the fact remains: an average investor would have been much better off owning the metals outright rather than owning miners or, worse yet, trying to turn himself into a superstar stock-picker (remember that the aforementioned peddlers have the benefit of hindsight).

That said, miners are indeed very oversold and very cheap at the moment and as such they might present a legitimate investment opportunity. Yet, we are not interested in taking it: we own metals primarily for safety and mining companies do not offer it. Moreover, history is on our side and we should see returns way in excess of those delivered by the miners. And after all is said and done, we could always buy them after the end of the bull and maybe still manage to reap gains larger than those of all the people who kept them for the whole period… We do not however exclude the possibility of trading miners, particularly at this very juncture, as their risk/reward profile appears excellent (in fact, we’re currently busy analysing a few mining companies).

E) The ‘70s Bull Market vs. the current one

We have already mentioned what happened to gold and silver relative to miners during the last bull market. There are however a couple other points worth mentioning that explain why we think this bull market is going to deliver larger gains than the past one and with lower drawdowns.

1) In the ‘70s, Gold had just started to trade freely

The bull market in gold officially started in 1966 (the year of the Dow/gold ratio high), but until March 1968 its price was artificially suppressed by the infamous London Gold Pool, which of course miserably collapsed as soon as market forces became too powerful for the high priests of interventionism to counter (by the way, the Gnomes of Zürich have to thank this fateful event for their now buoyant local gold market). Moreover, artificial pressures persisted until 1971, as the so-called “gold window” (the spread between the fixed gold/dollar exchange rate and the actual market price) allowed some of the shrewdest pool participants to convert their currency reserves into gold at the fixed price of $35/oz. and then sell it on the open market for a nice, risk-free profit. As a result, gold had quite a bit of catch up to do after the definitive end of the Bretton Woods system: it more than quadrupled in less than 3 years (it broke above 50$/oz. in the spring of 1972 and peaked at the end of 1974 at roughly 200$/oz.). This time around it took gold 7 or 8 years to complete the same feat, depending on whether one considers the 1999 bottom or the 2001 bottom as the starting point. This different behaviour also partly explains why in 1975 gold entered a two-year cyclical bear market that halved its price, whilst in 2008 it only corrected approximately 35% notwithstanding an epic panic and widespread liquidation that literally obliterated many other assets.

If we exclude three brief +20% corrections (two during the powerful advance of the early ‘70s and one towards the end of 1978), the mid-‘70s bear was the only one that occurred during that powerful bull market: apart from that, gold only experienced run-of-the-mill corrections of 15% or less. This should put things into perspective and help calm the fears of all those who are currently expecting 1400$ gold (or lower) on the basis that charts tell them this…The current bull has advanced in a much milder and more regular fashion and has already had four +/- 20% corrections (2003, 2006, 2008 and 2011/2012, the last two qualifying in our opinion as outright bear markets), hence it doesn’t strike us as in need of some sort of collapse to “wipe the slate clean”. The same is even truer for silver, which has always generously purged speculative excesses with 35% to 60% plunges.

The unexpected can of course always happen, but the above is one of the reasons why we tend to think that the current consolidation is all we will see: people waiting for 1400$ gold might end up being disappointed.

2) This time it’s much worse!

This is a quick point: the crisis of the ‘70s was undoubtedly a serious one, but we can guarantee you the current one dwarfs it. We won’t enter into details, suffice it to say that the fundamental backdrop is much less inspiring this time around (think of a secular crisis as opposed to a cyclical one: i.e. we’re now at the end of the rope). As such we expect gold to benefit from a much larger increase in reservation demand and, consequently, in its price.

This contributes as well to our scepticism towards claims that gold ought to “collapse” before being able to resume its advance.

Technicals, Sentiment and Positioning

The technical picture is rather benign for both metals:

Gold chart, via http://stockcharts.com/.

Silver chart, via http://stockcharts.com/.

As can be seen in the charts above, both have been spending quite some time in triangular consolidations from which they broke out higher during last summer. These bottoming processes have been accompanied by rising RSI and MACD indicators, with the latter showing remarkable bullish divergences in both cases. The metals are now in the process of recreating these formations on a smaller scale, significantly reducing their trading ranges in the process (a guarantee that a strong move is in the  makings). Strong support can be found in the 1550/1650$ area for gold and in the 26/30$ area for silver. Major resistance levels are 1800$ for gold and 35$ for silver: anything in between is just noise. Time also plays an important role here: the gold bear is roughly 18-month long and the silver one is approaching the 2-year mark. This all combines into a bullish picture: a long correction/consolidation with positive momentum divergences and strong support right underneath it in the context of a powerful secular bull market doesn’t sound so bad, does it?

So let’s see if sentiment and positioning agree with the above.

The former, as reported by Sentimentrader, is hardly buoyant: the readings on gold are currently below neutrality and actually close to levels only seen at major bottoms, including those of 2008, mid 2012 and December 2011. More importantly, they have been spending there quite some time since the 2011 top: another guarantee that there certainly isn’t any speculative mania going on (and if you still doubt it, then just spend some time on a few PMs forums…). The picture on silver is good, but less rosy: sentiment is below neutrality, but not particularly depressed. Moreover, it rose to relatively high levels during last autumn’s rally. Somewhat counterbalancing this is the fact that during last summer’s doldrums sentiment on silver plummeted to levels not even seen during the outright scary 2008 panic and stayed there for a relatively long period. All in all, we consider the sentiment picture positive and supportive of higher prices.

Positioning, on the other hand, is a bit more mixed… ETFs flows show that there has generally be a slow bleeding away from the precious metals sector, with GLD and GDX leading the way (SLV actually recorded its highest ever daily inflow on the 15th of January). Major bottoms tend however to be signalled by some sort of capitulation selling, where large amounts of money are withdrawn all at once from the ETFs. Rydex funds data also confirm that a notable retreat from the sector on the part of dumb-money investors took place during the recent correction. CoT reports unfortunately do not (yet) agree with the above: although both large and small specs have reduced their gold longs to a neutral level, we still do not see the hoped-for washout. And silver is even worse: both large and small specs continue to hold dangerously high levels of longs. We can only hope to see improved data this coming Friday. We want to point out that this fact does not make us bearish at all: it merely means that there could be scope for further corrections/mini-crashes to flush the specs out of the precious metals market.

A final note: we’ve been delighted to see a resurgence of the historical negative correlation between equities and gold, which was thrown under the bus during this last cyclical stock bull. It’s now obvious that gold is again ready to act as a “risk-off” investment, as it is fundamentally designed to do (and as in fact did in many prior instances, both recent and remote).

Conclusions

We are very bullish on gold and silver over the long term and we hold large positions in both metals (although we are overweight the former as it tends to deliver lower volatility and smoother, more regular returns). We intend to accumulate more should favourable circumstances present themselves (e.g. a washout bottom like last summer’s one or a convincing breakout above important resistance levels).
The current picture is however mixed: on the one hand, it’s clear to us that unless and until a new crisis phase opens up, precious metals will very likely continue to be the speculators’ “discarded toys”, abandoned in favour of hotter assets like equities (which on the contrary are currently sustained by the delusion that monetary hocus-pocus can possibly engineer prosperity); on the other hand technicals, sentiment and to a lesser extent positioning appear consistent with the notion that prices are way closer to a bottom than to a top. This week’s Commitments of Traders will help in ascertaining whether we are indeed ready to turn higher or not, as a marked reduction in speculative fervour is the last important ingredient still missing. We also remain convinced that last summer’s bottom was a major one, as it presented all the important characteristics that generally accompany a meaningful intermediate-term low: it’s very unlikely that it will turn out to be violated this year.
As always, we’ll keep our eyes open to spot important developments, but in the meantime we advise our readers to keep in mind the Golden Rule (“He who has the gold makes the rules”), as we believe it will be applied once again in a not-so-distant dystopian future where central banks’ and governments’ actions actually have consequences (and nasty ones to boot)…And of course we encourage them to engage in their own research!

If a Bull Market ends and no one is around to short it, does it make a top?

The objective of this post is to discuss the phenomena which usually accompany (and thus signal) the end of a bull market. These characteristics are generally present around the top of both secular and cyclical movements, although they obviously tend to be more evident in the former case than in the latter. 

It appears to us that currently one would be hard-pressed to find them in the Yen market, whilst they abound in the stock market. We suspect that a year from now the words of the immortal Jesse Lauriston Livermore could come in handy: “It didn't require a Sherlock Holmes to size up the situation.” 

The list we are presenting below isn’t complete: we have not included other factors which, although common, might fail to appear with such unwavering regularity, or others which we deem less important or less distinctive of a top.

The usual companions of a dying bull market

1. An already-deteriorating fundamental backdrop (often accompanied by an actual disregard for fundamentals)

This is by far the most important characteristic. It almost never fails to appear and it almost never fails to signal that the top is near. When the mania is underway, the public stubbornly refuses to listen to the various Cassandra foretelling doom on the basis of sound factual analysis and actual data: this explains why the highest prices in a bull market are always reached when the fundamental drivers which fuelled the move have already disappeared or at the very least have significantly deteriorated and are about to change direction.

Let’s take Apple as a recent example: as Reggie Middleton of BoomBustBlog has pointed out many times in his excellent Google vs. Apple analysis, when it traded at 700$ per share the company had already been outclassed by its competitors and was losing competitiveness and market share day after day, as well as starting to feel the pinch of margin compression. And yet you could hear nothing but bullish calls on it, everybody knew it was certainly going to go to 1000$ and everybody was invested. But in all fairness, we can’t blame the poor saps: “This time is different”, after all! 

In fact, it is not: failure to appropriately consider the fundamental landscape on the basis of the wrongly-held belief that some magical forces are at work which will undoubtedly cause prices to rise indefinitely always leads to financial disaster. It happened in 1929, when stocks supposedly reached “a permanently high plateau”; it happened in 2000, when conventional valuation methods were to be be discarded because internet companies were somehow held to be “different” (i.e. they could apparently survive without having to generate any profits or even revenues); it will happen again whenever a similar set of conditions will manifest itself. To again quote Livermore: “Another lesson I learned early is that there is nothing new in Wall Street. There can't be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.”

2. Widespread public participation

This is an easy point to make: if everybody is already in the market, who is actually going to come in and push prices even higher?! The moment one buys an asset, one becomes a bearish force in the market, since it’s logical that at that point one can only sell what it has previously bought (of course we’re omitting the possibility that one buys even more, something many chaps like to do at precisely the wrong time). 

It’s like an overcrowded boat where everybody leans to one side to watch a whale: by the time they’re all there, the whale is gone and the boat capsizes. Apple was (and probably still is) the most widely held stock amongst large mutual funds and hedge funds (and we suspect we could include the public as well). 

It’s never nice to be in room full of people when somebody yells “Fire!”, but this inevitably happens at the end of major bull runs, as herd behaviour, euphoria, greed and the fear of missing out push the unsuspecting public in the trap.

3. A blow-off top / Euphoric rally

The last consideration we have just made above serves us well in explaining this next point: when everybody (including previous disbelievers) finally becomes bullish and jumps on the proverbial bandwagon, a powerful (oftentimes almost parabolic) rally ensues, which culminates in a so-called blow-off top, after which prices generally collapse right away. Sometimes, as a new wave of fools, enticed by the “bargain”, rushes in, prices sharply recover and even make marginal new highs: this tends to happen more frequently in the stock market (as an example see the S&P500 between July and October 2007) than in other markets (like e.g. commodities). 

Of course the quasi-vertical rate of ascent witnessed during these runs is unsustainable and a big hint that it’s time to get out, but to the excited public it means nothing but the guarantee of even higher prices to come. During the last year of its uptrend, Apple saw its price almost double: quite an impressive feat for a stock with such a large capitalization. But after all it was meant to go to 1000$…

4. Overly bullish and complacent sentiment

Daring to call a top of a bubble near its actual peak can prove detrimental to one’s health: people, excited by their own delusions, angrily and rabidly turn against all those who try to spoil their dreams of boundless wealth. Rational investors suddenly become “losers”, “haters”, “failures” and all reasoned arguments forwarded by them become irrelevant, since “this time is different” etc. Intoxicated by the artificial abundance of paper money and bank credit, the wonderfully irrational animal that man is happily engages in all sorts of unsustainable bubble activities, convinced that “no harm will befall you, no disaster will come near your tent” and that the Land of Cockaigne is just around the corner: all is needed is for the party to last a bit longer and not surprisingly party poopers are not welcome. 

Of course, this is nothing but a bitter illusion and the ensuing reality is even bitter. As Mises so aptly put it: “The popularity of inflation and credit expansion, the ultimate source of the repeated attempts to render people prosperous by credit expansion, and thus the cause of the cyclical fluctuations of business, manifests itself clearly in the customary terminology. The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers' stone to make it last.”  

These considerations and Mises’s wise words apply to speculative excesses in financial markets as well: conventional wisdom postulates that when something has been going up for quite some time, then it logically follows that it can only continue to go up and those who refuse to acknowledge it have simply missed the boat…The reality is that whenever excessive bullishness, complacency, overconfidence and sheer euphoria abound, then it’s time to quietly take the other side of the public’s bet. And the unchanging human nature (helped along by the ministrations of the inflationists) ensures that after the bust the cycle is going to repeat.

Extraordinary Popular Delusions and the Madness of Crowds offers to the interested reader a colourful account of some of the most incredible historical episodes of collective folly. Doug French’s book Early Speculative Bubbles and Increases in the Supply of Money analyses the underlying economic causes of some of those same phenomena from an Austrian perspective. Gustave Le Bon’s and Humphrey B. Neill’s works are nice companions to the above books.

5. Extensive News coverage / Outlandish predictions

A useful rule of thumb is: whenever something has gone up so much that it makes for rosy newspaper headlines, then it’s time to sell it. 

The mainstream media are usually the last ones to jump on the aforementioned bandwagon: they need exciting stories that cater to a large audience, hence they all follow the latest fads. To make their products even more enticing, they generally add generous helpings of hype. 

It follows that the end of a bull run is usually accompanied by armies of cheerfully bullish journalists who regurgitate the most trite arguments to justify their (or some expert’s) shameless predictions, which usually prove to be just a stinky pile of rubbish. For a recent example, please watch this video (we want to warn our readers: even people with only half a brain will likely find it extremely annoying).

6. The initial trend change is met with scepticism (buy-the-dip mentality)

Since in the public’s mind a raising market can only go higher, all sell-offs and corrections are viewed as opportunities to get in. This belief has been reinforced during the course of the entire bull market, where all sell-offs and corrections were indeed opportunities. Unfortunately, this fails to hold true at the top, where distribution takes place: early participants (astute investors) sell their stakes to latecomers (your proverbial dentist). Countless investors have been ruined by buying one dip too much. 

This phenomenon is also due to the fact that the euphoric mental state that we discussed above acts as a filter that automatically prevents people’s brains from contemplating negative outcomes. Pride, the desire to be right and blind hope contribute to it as well. 

It’s important to note, however, that this generally happens only at the end of major bull runs in stocks, since commodities have the pesky attitude of crashing much more swiftly.

Conclusion

We hope to have provided our readers with a brief, to-the-point list of phenomena that usually accompany the end of a bull market. We’ll leave it to them to ascertain in which markets it is today possible to find all or most of them busily at work. 

We want to stress that these are helpful yet imprecise tools: they can’t endow an investor with the ability to spot exact tops; they can however help him in identifying approximate turning points, or at the very least moments when the risks of buying something greatly outweigh the prospective returns. 

Howard Marks’s last letter to his clients does a great job at explaining both the difficulties and the importance of being a contrarian: we suggest our readers save the PDF and peruse it every time they feel compelled to run with the herd. In investing what feels comfortable is rarely profitable and as the brilliant Ed Seykota once said “If comfort is your goal, stop trading.”