How Reliable is the S&P’s ‘Death Cross’ Pattern?

Mechanical chartists say that with the recent stock market collapse, the technical picture of the US S&P 500 have been irreparably deteriorated such that prospects of a decline is vastly greater (which has been rationalized on a forthcoming recession) than from a recovery. The basis of the forecast: the Death Cross or ‘A crossover resulting from a security's long-term moving average breaking above its short-term moving average or support level[1]’.

First of all, I’ve seen this picture and the same call before.

In July of last year, the S&P also experienced a similar death cross. Many articles emphasized on the imminence of a crash[2] that never materialized.

Secondly, I think applying statistics to past performances to generate “feasible” odds on a bet based on the ‘death cross’ represents as sloppy thinking

To wit, betting based on a ‘death cross’ signifies a gambler’s fallacy or fallacy committed when a person assumes that a departure from what occurs on average or in the long term will be corrected in the short term[3].

A coin toss will always have a 50-50 head-tail probability distribution. If the random coin toss exercise would initially result to string of ‘heads’ outcome, the eventual result of this repeated exercise would still result to a 50-50 outcome or a zero average, as shown by the chart below.

As the illustrious mathematician Benoit Mandelbroit wrote[4],

If you repeat a random experiment often enough, the average of the outcomes will converge towards an expected value. With a coin, heads and tails have equal odds. With a die, the side with one spot will come up about a sixth of the time

Applied to the death cross, we see the same probability 50-50, because each event from where the ‘death cross’ appears entails different conditions (finance, market, politics, social, cultural, even time and spatial differences and etc), as earlier argued[5]. It would signify a sheer folly to oversimplify the cause and effect order and speciously apply odds to it.

Proof?

One would hear proponents bluster over the success of the death cross in 2000 and 2007. Obviously the hindsight bias can be very alluring but deceptive. The causal relationship which made the ‘death cross’ seemingly effective in 2000 and 2007 for the US S&P 500 had been mostly due to the boom bust cycles which culminated to a full blown recession or a crisis during the stated periods.

The death cross was last seen in July of last year (green circle above window), but why didn’t it work? The answer, because the death cross had been pulverized by Bernanke’s QE 2.0 (see green circle chart below). When Mr. Bernanke announced QE 2.0, the ‘death cross’ transmogrified into a ‘golden’ cross!!! This shows how human action is greater than historical determinism or chart patterns.

Many mistakenly think that chart patterns has an inherently built in success formula which is magically infallible, as said above, they are not.

Third, not all market crashes has been due to recessions.

The above illustrates the crash of 1962 (upper window) and 1987 (lower window)[6]. This is obviously unrelated to the death cross, however the point is to illustrate that not every stock crash is related to economic activities. The recent crash may or may not overture a recession.

Bottom line: The prospective actions of US Federal Reserve’s Ben Bernanke and European Central Bank’s Jean-Claude Trichet represents as the major forces that determines the success or failure of the death cross (and not statistics nor the pattern in itself). If they force enough inflation, then markets will reverse regardless of what today’s chart patterns indicate. Otherwise, the death cross could confirm the pattern. Yet given the ideological leanings and path dependency of regulators or policymakers, the desire to seek the preservation of the status quo and the protection of the banking class, I think the former is likely the outcome than the latter.

And another thing, we humans are predisposed to look for patterns even when non-exist, that’s a result of our legacy or inheritance from hunter gatherer ancestors’ genes whom looked for patterns in the environment for survival or risked being eaten alive by predators. This behavioural tendency is called clustering illusion[7]. A cognitive bias which we should keep in mind and avoid in this modern world.

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[1] Investopedia.com Death Cross

[2] The Economic Collapse Blog, The Death Cross: Another Sign That We Are On The Verge Of A Recession?, July 5, 2010

[3] Nizkor.org Fallacy: Gambler's Fallacy

[4] Mandelbrot, Benoit B The (mis) Behaviour of Markets, Profile Books p.32

[5] See The Causal Realist Perspective to the Phsix-Peso Bullish Momentum, July 10, 2011

[6] About.com Stock Market History

[7] Wikipedia.org Clustering illusion

Why The Current Market Volatility Does Not Imply A Repeat Of 2008

``The confusion of inflation and its consequences in fact can directly bring about more inflation.”-Ludwig von Mises

Every time financial markets endure a convulsion, many in the mainstream scream “DEFLATION”!

Like Pavlov’s dogs, such reaction signifies as reflexive response to conditioned stimulus, otherwise known as ‘classical conditioning’[1] or ‘Pavlovian reinforcement’.

Where the dogs in the experiment of Russian Nobel Prize winner Ivan Pavlov would salivate, in anticipation of food, in response to a variety of repeated stimulus applied (although popularly associated with the ringing of bells, but this hasn’t been in Ivan Pavlov’s account of experiments[2]), the similar reflexive interpretation by the mainstream on falling markets is to allege association deflation as the cause.

Not All Bear Markets Are Alike

Yet not all bear markets are alike (see figure 1)

Figure 1 Economagic: S&P 500, CRB Commodity Index and 10 year treasury yields

As one would note, the bear markets of the 70s came in the face of higher treasury coupon yields, represented by yields of 10 year treasuries (green line), which accounted for high inflation. This era of ‘high inflation-falling market’ phenomenon (or stagflation) is especially amplified in the recessions of 1974, 1980 and 1982 (shaded areas) as markets have been accompanied by soaring commodity prices (CRB Index-red line).

Thereby, the 1970s accounted for ‘deflation’ in terms of stock prices, borrowing the definition of the mainstream, amidst a high inflation environment, as referenced by rising consumer prices. As you would also note, the term ‘deflation’ is being obscured and deliberately misrepresented, since markets then, adversely reacted to the recessions brought about by a high inflation environment.

I’d also like to point out that surging inflation and rising stocks can be observed in 1975-1981, in spite of the 1980 recession. Although of course, the real returns were vastly eroded by the losses in purchasing power of the US dollar.

But in anticipation to the objection that high interest rates and high inflation extrapolate to falling stock markets, this isn’t necessarily true. As shown in the above, stocks can serve as an inflation hedge. And one can see a present day paradigm of this ‘surging inflation-rising stock markets’ dynamic unfolding in Venezuela!

Comparing 2010 To 2008

We always say that markets operate in different environments, such that overreliance on historical patterns could prove to be fatal. While markets may indeed rhyme or have some similarities, the outcomes may not be the same, for the simple reason that people may react differently even to parallel conditions.

For us, what is important is to anticipate how people would possibly react to the incentives provided for by current operating conditions.

We have been saying that this isn’t 2008. There is no better proof than to show how markets have responded differently even if many are conditioned to see the same (see figure 2) out of bias.

Figure 2: stockcharts.com: Market Volatility of 2008 and 2010

If one would account for the major difference between 2008 and 2010, it is that markets today appear to be pre-empting a 2008 scenario.

In 2008 (chart on the left window represents the activities of the year 2008), the post Lehman bankruptcy saw the S&P crash first before other markets followed, particularly oil (WTIC), and the Fear Index (VIX).

Even the US 10 year treasury yields (TNX) reacted about a month AFTER the crash in the S&P 500. This belated impact could be due to the spillover effects from the large build up of Excess Reserves (ER) to interbank lending rates as the increased in supply lowered rates at the front end, aside from ‘flight to safety’ reasons, which curiously emerged a little past the peak of the crash.

This time around (right window is the 2010 year-to-date performance), the market’s reaction has been almost simultaneous, this perhaps partly reflects on the Pavlov conditioned stimulus. And this could be the reason why many cry out “deflation”, when they seem to be deeply confused about the referencing of the term.

As we’d like to repeat, falling markets don’t reflexively account for ‘deflation’. Dogs do not think, but we do; therefore, we must learn to distinguish from the fallacies of ‘conditioned stimulus’ with that of the real events.

Besides, the fixation on ‘conditioned stimulus’ can account for, in behavioural science, as ‘anchoring’ effect, or where people’s tendency is to “rely too heavily, or "anchor," on a past reference or on one trait or piece of information when making decisions (also called "insufficient adjustment")[3]”. In short, trying to simplify analysis by means heuristics through anchoring is likely to be flawed one. And investors would only lose money from sloppy thinking.

Yet it is also worth pointing out that price level conditions of 2008 appear to be different.

In today’s market tumult, the fear index (VIX) has been rising but is still far away from the highs of 2008; where the highs of today are the low of 2008! Moreover while oil prices have dramatically fallen, an equally swift reversal seems to be in place!

Gold Sets The Pace

Figure 3: stockcharts.com: The Faces of Gold and Silver in 2008 and 2010

Another feature in 2008 which looks distinct today is the reactions in the precious metal markets (see figure 3).

In 2008 (left window), gold prices reacted instantaneously with the collapse in the S&P 500, but recovered about a month after, just as other markets displayed the aftershocks. Gold’s recovery portended a strong rebound in risks assets thereafter.

In 2010 (right window), we seem to be seeing an abridged (déjà vu?) version of 2010 for gold only. Gold appears to have responded in the same fashion by falling with the initial shock in global stock markets. But this seems to be ephemeral as gold prices appears to have bounced back strongly.

Yet Gold prices are only a stone throw’s distance from its record nominal highs. And if Greece would serve as an indicator of the direction of Gold’s prices, which reportedly were recently priced at 40% premium of the current spot prices or at $1,700 per ounce, then we could see gold prices closing this gap over the coming months.

Nevertheless, if inflation and deflation are defined in the context of changes in the purchasing power of money (the exchange ratio between money and the vendible goods and commodities), then gold, which isn’t a medium of exchange today, but a reserve asset held only central banks, are unlikely to function as a deflation hedge for the simple reason that our monetary system operates under a legal tender based fiat ‘paper’ money standard[4].

In an environment where people scramble for cash or see an enormous increase in the demand for cash balances, gold which isn’t money (again in the context of medium of exchange), won’t serve as a hedge. It is counterintuitive to think why people should buy gold when cash is what is being demanded.

Figure 4: Uncommon Wisdom[5]: Rising Gold Prices In Major Currencies

Hence rising gold prices represents either expectations of increases in inflation or symptomatic of a burgeoning monetary disorder. And since gold prices are up relative to all major currencies (see figure 4), then obviously, it would appear to be the latter.

So it would be another flagrant self-contradiction to argue for ‘deflation’ when markets are signalling possible distress on the current currency system.

And when people lose trust in money, this is not because of ‘deflation’ (where people have more trust in it), but because of inflation—the loss of purchasing power.

One very good example should be Venezuela. As Venezuela’s President Hugo Chavez regime seems hell bent to turn her country into a full fledged socialism, the bolivar, Venezuela’s currency, seem in a crash mode. Capital flight has been worsening in the face of soaring inflation. The Chavez regime is reportedly trying to arrest ‘inflation’ and the crashing ‘bolivar’ by raiding the foreign exchange black market[6]. Mr. Chavez does not tell the public that his government has been printing money like mad.

One objection would be that the US isn’t Venezuela, but this would be a non-sequitur, the point is people flee money because of inflation fears and not due to ‘deflation’ expectations. So rising gold prices are indicative of monetary concerns and not of deflation.

The Difference Of Inflation And Deflation

On a special note, I’d like to point out that it is not only wrong to attribute the impact of deflation and inflation to unemployment as similar, this is plain hogwash and signifies as misleading interpretation of theory.

Here, deflation is being referenced as consequence of prior policy actions of inflationism, which leads to unemployment. In other words, unemployment is the result of unwinding of malinvestments from previous bubble policies from the government which isn’t caused by ‘deflation’ per se.

Where the rise in purchasing power means cheaper goods and services or where people can buy more stuff, how on earth can buying more stuff (deflation) and buying less stuff (inflation) be deemed as equal?

Besides, based on the political aspects of the distribution of the credit process, inflation benefits debtors at the expense of the creditors, and vice versa for deflation. As Ludwig von Mises clearly explained[7],

``Many groups welcome inflation because it harms the creditor and benefits the debtor. It is thought to be a measure for the poor and against the rich. It is surprising to what extent traditional concepts persist even under completely changed conditions. At one time, the rich were creditors, the poor for the most part were debtors. But in the time of bonds, debentures, savings banks, insurance, and social security, things are different. The rich have invested their wealth in plants, warehouses, houses, estates, and common stock and consequently are debtors more often than creditors. On the other hand, the poor-except for farmers—are more often creditors than debtors. By pursuing a policy against the creditor one injures the savings of the masses. One injures particularly the middle classes, the professional man, the endowed foundations, and the universities. Every beneficiary of social security also falls victim to an anti-creditor policy.

``Deflation is unpopular for the very reason that it furthers the interests of the creditors at the expense of the debtors. No political party and no government has ever tried to make a conscious deflationary effort. The unpopularity of deflation is evidenced by the fact that inflationists constantly talk of the evils of deflation in order to give their demands for inflation and credit expansion the appearances of justification.” (bold highlights mine)

And this is apparently true today. Governments (global political leaders and the bureaucracy), the global banking and financial system and other political special interest groups (e.g. labor union in the US), which have benefited from redistributive “bailout” policies, have done most of the borrowing (see figure 5).

Figure 5: Businessinsider[8]: Total Debt To GDP by Major World Economies

Yet, the current inflationist policies, e.g. zero interest rates, quantitative easing, bailouts, subsidies and etc.., have been designed to filch savings of the poor and the middle class to secure the interests of these debtors.

So deflation isn’t a scenario that would be easily embraced by these interest groups, who incidentally controls the geopolitical order. Where deflation would reduce their present privileges ensures that prospective policy actions will be skewed towards the path of more ‘inflationism’.

Hence the political aspects of credit distribution, variances in the changes in purchasing power from politically based policies and the ramifications of inflationism does not only translate to a difference in the impact of inflation and deflation on every aspect of the markets and the economy, but importantly, tilts the odds of policies greatly towards inflationism. And eventually these policies will be reflected and/or vented on the markets.

For deflation to take hold would extrapolate to a major shift in the mindset of the mainstream politics.

Again deflation-phobes try to justify inflationism by the use of specious, deceptive and fallacious reasoning.

Groping For Explanation And The Bubble Mechanism

Another reason why today is going to be different from 2008, is that during the last crisis, the public single-mindedly dealt with the busting of the US housing bubble. First it was the collapse of mortgage lenders, then the investment banks, and the eventual repercussion to the US and global economies.

Today, the public seems confounded about the proximate causes of market volatility; there have been many, including the default risks of Greece, a banking system meltdown in the Eurozone, dismemberment or collapse of the EURO (!!!), another housing crash in the US, a China crash, and for fans of current events the standoff in the Korean Peninsula[9]!

And all these groping in the dark for an answer or for an explanation to the current market circumstances implies rationalization or information bias arising from “people’s curiosity and confusion of goals when trying to choose a course of action”[10].

When the public seems perplexed about the real reasons, then this volatility is likely a false signal or a noise than an inflection point.

Moreover, the alleged collapse of the Euro seems the most outrageous and symptomatic of extreme pessimism. Not that I believe in the viability of the Euro, I don’t. But such myopic assumptions ignore some basic facts, such as the recently reactivated swap lines by the US Federal Reserve--which incidentally have been insignificantly tapped, to which could possibly be indicative of less anxiety; according to the Wall Street Journal[11] ``reduced demand indicates that conditions are stable enough that overseas banks aren’t willing to tap into the swaps”--and that the IMF will contribute to the “bailout” of the Eurozone[12], which makes the Euro bailout a global action mostly led by the US.

Of course if the conditions will worsen in Europe, then it is likely that the US Federal Reserve may reduce its penalty rate to these emergency facilities to encourage increased access.

All these simply reveals of the cartel structure of global central banking system. This means that central banks around the world will likely work to buttress each other, as we are seeing now, to ring fence the banking system of any major economy from a collapse that could lead to a cross country contagion.

The Wall Street Journal quotes, Federal Reserve of St. Louis President James Bullard[13], ``Major nations “have made it very clear over the course of the last two years that they will not allow major financial institutions to fail outright at this juncture.” Since these “too-big-to-fail guarantees are in place, the contagion effects are much less likely to occur.” (emphasis added)

The sentiment of Mr. Bullard illuminates on the prevailing mindset of the monetary and political policymakers. Hence governments will continue to inflate, which has been the case, as we have rightly been arguing[14].

However, inflation as a policy is simply unsustainable. Hence, in my view, the current paper money system will likely tilt towards a disintegration sometime in the future. That crucial ordeal is not a matter of IF but a question of when. Of course, the other alternative, that could save the system, would be through defaults. But since debt defaults are likely to reduce the political and financial privileges of those in and around the seat of power, it is likely a contingent or an action of last recourse.

This means that default, may be an option after an aborted attempt to ‘hyper or super’ inflate the system. Where the consequences may be socially traumatic that would lead to a change in the outlook in public sentiment, only then will these be reflected on the polity.

Yet, both these scenarios aren’t likely to happen this year or the next, for the simple reason that consumer inflation is yet suppressed, which is likewise reflected on current levels of interest rates. And these artificially low rates allow governments more room to adopt popular inflationist measures[15].

And 2008 could be used as an example for this boom bust mechanism, where oil prices soared to a record high of $147 per barrel even as the economy and the markets were being blighted by strains from the housing bubble bust. The record high oil prices, weakening of the economy, the spreading of the unwinding of malinvestments and the mounting balance sheet problems of the banking and financial system all combined to serve as manifestations of a tightened monetary environment that seem to have immobilized the hands of officials relative to market forces. Eventually the culmination of these concerted pressures was seen in the ghastly crash of global asset markets.

Again this isn’t the case today.

Influences Of The Yield Curve, China and Political Markets

This also leads us back to our long held argument about the impact of the yield curve to the markets and to the economy[16].

The Federal Reserve of Cleveland demonstrates the effects of the yield curve to the real economy (see figure 6)

Figure 6 Federal Reserve of Cleveland: The Yield Curve May 2010

Inverted yield curves have been quite reliable indicators of recessions and economic recovery or the business cycles.

Yield curves tend to have 2-3 years lag. The recession of 2008-2009, was clearly in response to or foreshadowed by an inverted yield curve in early 2006-2007 (right window). Since the world went off the Bretton Woods gold dollar standard in 1971, the yield curve cycles have had very strong correlations, if not perfect (left window) with market activities and the real economy.

It is true that the past may have different influences in today’s yield curve dynamics, as Joseph G. Haubrich and Kent Cherny of the Federal Reserve of Cleveland[17] writes,

``Differences could arise from changes in international capital flows and inflation expectations, for example. The bottom line is that yield curves contain important information for business cycle analysis, but, like other indicators, they should be interpreted with caution.”

Nevertheless in contrast to the mainstream, which has patently ignores this important variable and instead continually blether about liquidity trap and ‘deflation’, one reason to depend on the reliability of the yield curve is due to the “profit spread”.

Again we quote anew Murray N. Rothbard[18],

``In their stress on the liquidity trap as a potent factor in aggravating depression and perpetuating unemployment, the Keynesians make much fuss over the alleged fact that people, in a financial crisis, expect a rise in the rate of interest, and will therefore hoard money instead of purchasing bonds and contributing toward lower rates. It is this “speculative hoard” that constitutes the “liquidity trap,” and is supposed to indicate the relation between liquidity preference and the interest rate. But the Keynesians are here misled by their superficial treatment of the interest rate as simply the price of loan contracts. The crucial interest rate, as we have indicated, is the natural rate—the “profit spread” on the market. Since loans are simply a form of investment, the rate on loans is but a pale reflection of the natural rate. What, then, does an expectation of rising interest rates really mean? It means that people expect increases in the rate of net return on the market, via wages and other producers’ goods prices falling faster than do consumer goods’ prices.”

In short, interest rates which fuels boom-bust cycles, also represents the profit spreads in the credit market as seen in the context of ``saving, investment, and the rate of interest are each and all simultaneously determined by individual time preferences on the market.[19]”

And considering that all the major economies are now on zero bound interest rates (which is likely to be extended), has steep yield curves and are engaged in some form of quantitative easing, while interest rates remain low, as seen in the long term yields of major economies sovereign papers and muted consumer price inflation, it is my impression that there won’t be any crashes, as peddled by the perma bears.

Of course, this is conditional to the surfacing of tail risks such as political accidents e.g. outbreak of military clash in the Korean Peninsula, unilateral call by Greece to default or secede from the European Union, and a crash in China etc...

And speaking of China we learned the authorities have shifted gears from “tightening” back to an “accommodating” policy (see figure 7).

Figure 7: Businessinsider[20]: China Is Back To Pumping Liquidity Into Its Financial System

Again this gives more credence to our view that policymakers approach social problems by throwing money at them, by regulation or by taxation or by a change in leadership[21]. All of which are meant to resolve the visible short term effects at the expense of the future.

Finally, Ludwig von Mises[22] on the deliberate distortions of the terms of inflation and deflation,

``The terms inflationism and deflationism, inflationist and deflationist, signify the political programs aiming at inflation and deflation in the sense of big cash-induced changes in purchasing power.”

In short, everything about the markets is now politics.

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[1] Wikipedia.org, Classical Conditioning

[2] Wikipedia.org, Ivan Pavlov

[3] Wikipedia.org, Lists of Cognitive Bias

[4] See In Greece, Gold Prices At US $1,700 Per Ounce!

[5] Brodrick, Sean, Get Your Gold and Silver Coins Now, Uncommon Wisdom

[6] Businessweek, Chavez Says Unregulated Currency Market May Disappear

[7] Mises, Ludwig von Interventionism: An Economic Analysis by Ludwig von Mises

[8] Businessinsider, Here's Everyone Who Would Get Slammed In A Spanish Debt Crisis

[9] See On North Korea's Brinkmanship

[10] Wikipedia.org, Information Bias

[11] Wall Street Journal Blog, A Look Inside the Fed’s Balance Sheet

[12] See The Euro Bailout And Market Pressures

[13] Wall Street Journal Blog, Fed’s Bullard: Europe Woes Unlikely to Trigger Another Recession

[14] See Why The Greece Episode Means More Inflationism

[15] See Global Markets Violently Reacts To Signs Of Political Panic

[16] See Influences Of The Yield Curve On The Equity And Commodity Markets

[17] Haubrich, Joseph G. and Cherny, Kent, Federal Reserve of Cleveland, The Yield Curve May 2010

[18] Rothbard, Murray N. America’s Great Depression

[19] Ibid

[20] Businessinsider: China Is Back To Pumping Liquidity Into Its Financial System

[21] See Mainstream’s Three “Wise” Monkey Solution To Social Problems

[22] Mises, Ludwig von Cash-Induced and Goods-Induced Changes in Purchasing Power, Human Action, Chapter 17 Section 6

Four Reasons Why ‘Fear’ In Gold Prices Is A Fallacy

``The danger from all forms of paper money controlled and regulated by governments or their appointed central banks is that they remain creatures of the political process, and dependent upon the knowledge and policy preferences of those who have the power over the monetary printing press. The history of paper monies is a sorry story of inflations, currency depreciations, and resulting social and economic disorder.”-Richard M. Ebeling, IMF Special Drawing Right "Paper Gold" vs. a Real Gold Standard

The recent weakness in gold prices has prompted some mainstream commentaries to suggest “fear” as the main driving force behind this.

The underlying premise is that since gold competes with every other asset class for the investor’s money, the recent surge in global stock markets may have revived “risk” taking appetite or the Keynesian “animal spirits”. And since gold has been seen as less attractive alternative, investors may have possibly sold gold and subsequently bought into the stock markets. Hence the recent selloff has had “fear” imputed on gold prices.

For me, this represents sloppy reasoning unbacked by evidence which has been “framed” in very short term horizon, the anchoring bias or the ``tendency to rely too heavily, or "anchor," on a past reference or on one trait or piece of information” in their analysis and an innate prejudice against the “barbaric metal”.

Such flawed analysis omits the following perspective:

1. Prices Are Relative.

As we discussed in Expect A Different Inflationary Environment, inflation moves in stages and would likely impact asset classes in a dissimilar mode.

From our perspective the stock markets and commodities have initially been the primary the absorber of government induced “reflationary” measures.

In other words, yes, a rotation will likely be the case, but this doesn’t imply “fear”. It simply means a pause in the trend because NO trend moves in a straight line. It is that elementary.

The same analogy can be ascribed to last year’s dreadful financial markets collapse, where many left leaning analysts have imputed “capitalism is dead”. The truism is that markets aren’t fated to move in one direction, because they always reflect on the fluid pricing dynamics by the different participants in response to perpetual changes in the flow of information as reflected by the changes in the environment.

But when markets are tweaked by governments to achieve a perennial boom, they attain the opposite outcome- a short-term euphoric boom and an equally devastating bust or the bubble cycle.

Mr. Bill Bonner in U.S. Banks Overrun by Dirty, Rotten Scoundrels eloquently describes this phenomenon, ``Capitalism is not a collection of nuts and bolts, gears and switches. Instead, it is a moral 'system.' 'Do unto others as you would have them do unto you,' is all you need to know about it. And like any moral 'system,' it rarely gives the capitalists what they hope for...or what they want. It gives them what they deserve. And right now, it's giving it to them good and hard.” (bold emphasis mine)

In short, losses are inherent features of the marketplace. Hence, they are reflected in trends or in cycles see figure 1.

Figure 1: stockcharts.com: Gold: Where’s The Fear?

Over the past three years we see some correlations among different markets, yet these correlations haven’t retained a fixed balance but instead have been continually evolving in a seemingly divergent fashion.

In 2006-2007 Gold (main window) soared along with the global stock markets (DJW), as the US Dollar index (USD) had been on a decline (see blue trend lines). So from this perspective alone, the premise that gold falls on higher stock markets simply DOESN’T HOLD. One could easily make the oversimplified case where the inflationary ramifications of a falling US dollar had fueled a frenzy over gold and global stock markets until this culminated.

But the past dynamics have been reconfigured.

Late last year, the spike in the VIX or the “Fear” index coincided with a surge in the US dollar as a majority of global stock markets went into a tailspin. Gold similarly melted. But in contrast to the stock markets, gold found an early bottom which corresponded with a peak in the US dollar and the VIX index. This apparently marked the end of an INVERSE or NEGATIVE correlation between gold and the US dollar.

In this landscape marked by FEAR, one can infer that the US dollar functioned as the sole “safehaven” from the banking meltdown triggered investor exodus in global stock markets and in gold. But apparently this dynamic appears to be a short term affair and may have signified as a ‘one-time’ event that marked the extraordinary market distress or dislocation-our Posttraumatic Stress Disorder PTSD.

In 2009, these dynamics have been rejiggered anew. From the start of the year, Gold strongly rallied but “peaked” alongside the US dollar index (see red arrows) concurrent to the decline in the fear index and a revival in global stock markets.

The falling US dollar and declining gold prices have reversed the NEGATIVE correlation to a POSITIVE correlation where both have moved in the same direction. The implication is that the US dollar, the VIX “fear” index and Gold encapsulated the investor’s negative sentiment, all of which have recently declined. And subsequently, the stock market rally has been “fueled” by the revival of the animal spirits, according to the fear believers.

Hence, the swift “rationalization” that investor’s negative sentiment has reversed course and has passed on the “fear factor” burden to “gold”.

Yet, this ignores the fact that both the US dollar index and gold are still on an UPTREND from the basis of the simultaneous lows last October. To reiterate, from their lows both had been positively correlated.

Stretching the picture, gold remains entrenched in a bullmarket since 2001, while the US dollar’s newfound virility could signify as either a cyclical rally within long term bear market or as a fledging bull.

But since gold represents as the nemesis of the paper money system (as seen by Keynesians-ergo “barbaric” metal) epitomized by the US dollar hence price action should reveal an inverse correlation. But this hasn’t been the case today, or as it had similarly been in 2005, where both the US and gold rose even amidst a milieu of rising stock markets.

Yet such positive correlation between gold and the US dollar may account for many variable reasons for the aberration. Since the US dollar index is significantly weighted towards the Euro this could mean a frailer European economy than the US, investor’s perception of Europe’s banking system as relatively more vulnerable, the deleveraging process continues to manifests of sporadic US dollar shortages in the global financial system, and etc.., but this seems likely to be temporary.

Nonetheless given that gold has been in a longer and a more solid trend of 8 years, combined with the fundamentals of the growing risks of unintended consequences by the collective money printing financed spending spree by governments, our money is on gold.

2. Governments Have Been Distorting Every Market Including Gold.

It’s quite naïve for anyone to docilely believe that the gold markets have been efficiently reflective of the genuine market based fundamentals, when almost every financial markets have seen massive scale of interventions from global governments.

To consider, the gold markets despite its relative smaller breadth (estimated at $4 trillion of above gold stocks and $150 billion gold mining stocks measured in market capitalization) has been a benchmark closely monitored by Central Bankers. For example the speech of Federal Reserve Chairman Ben Bernanke entitled as Money Gold and the Great Depression reinforces this view.

It is because gold has functioned as money for most of the years since humanity existed. So it isn’t just your ordinary or contemporary commodity.

In fact, this has been the 38^th year where our monetary system has operated outside the anchors of gold or other commodities. Alternatively, this represents as the boldest and grandest experiment of all time [see our earlier article Government Guarantees And the US Dollar Standard]. Remember, all experimentations of paper money system that has ever existed perished due to “inflationary” abuses by governments.

In other words, government distortions may cloud interim activities in the gold market, but this doesn’t suggest of a reversal of its long term trend. Thus, this isn’t fear.

The unstated overall goal of collective governments today is to revive the status quo ante environment predicated on the paradigm of borrow-spend-speculate policies. Thus an all out effort is being waged.

That’s why global central banks have geared policy interest rates towards ZERO-in the name of providing liquidity. That’s why global central banks have resorted to the printing press or in technical terms “quantitative easing” and absorbed various junks from the banking system-in the name of “normalizing” the credit process. And that’s why governments have thrown or indiscriminately spent enormous sums of money into the global financial and economic system-in the name of sustaining aggregate demand.

In essence, they want everybody to stop saving and indulge in a binge of borrowing, spending or speculating in order to drum up the “animal spirits”.

For those with common sense, we understand that these policies are simply unsustainable. And unsustainable policies eventually will unravel.

Yet why are these being practiced? Because of sundry political reasons-primarily to expand the presence of government in the system.

When gold defied the “deflationary outlook” which infected almost all asset classes, we argued that governments could have wanted a higher gold prices as signs of reviving inflation [see Do Governments View Rising Gold Prices As An Ally Against Deflation?]. With the present developments, this has changed.

Since the overall goal of governments is to revive the “animal spirits”, then rising stock markets serves as a vital instrument to project these reinvigorated investor sentiment. Now that stock markets have been sensing signs of emergent inflation, gold markets are being targeted as the traditional adversary.

Proof?

Take the publicized plan by the G-20 to sell part of IMF’s gold stash of 403 tons out of the 3,200 tons it holds which is the third largest after the US and Germany.

You’d be wondering why the efforts by the G-20 to broadcast sales, considering the substantial size, would have a negative short term impact on gold prices even prior to the actual sales.

A normal seller in the marketplace would have the incentive to get the best possible price in exchange for the goods or services being sold. Hence if the IMF aims to achieve optimum prices from its sales it should conduct its program discreetly. But this isn’t so. Obviously the announcement of proposed gold sales would result to depressed prices even prior to the action itself. Therefore, this wouldn’t account for an “economically rational” seller but one shrouded by political motivations.

Factually, this is just one of the psychological tools employed by central bankers when manipulating the currency market. They call this the “signaling channel”.

According to IMF’s Division Chief of the Research Department, in his article Turning Currencies Around, ``Through the signaling channel, the central bank communicates to the markets its policy intentions or private information it may have concerning the future supply of or demand for the currency (or, equivalently, the path of interest rates). A virtuous expectational cycle can emerge: for instance, if the central bank credibly communicates its belief that the exchange rate is too strong—and would be willing to change policy interest rates if necessary—then market expectations will lead to sales of the currency, weakening it as intended.” (bold underscore mine)

In short, G 20 policymakers have been using conventional currency manipulation tactics to put a kibosh on the gold market.

Moreover, the same article on the G 20 gold sales from CBS Marketwatch reports that the European Central bank had “completed the sale of 35.5 tons of gold” late March.

Another, there have been discussions in cyberspace on the unverified interventions by the European Central Bank to save Deutsche Bank from its short positions.

The point is you can’t ascribe fear when knowingly such markets are being cooked up for some political purposes, although the superficial nature of market manipulations ensures that the impact will be felt on a short term basis.

But even as the G-20 has been attempting to maneuver the gold markets, actions by one party appear to be offset by the actions of another.

Apparently China has been doing the opposite of the G-20. Instead of publicly airing its intent to increase gold reserves, it has tacitly been amassing gold from its domestic producers and from the domestic market (mineweb.com) to see a 75% surge in gold reserve holdings to 1,054 tonnes in 2008 from the 600 tonnes in 2003. (AFP)

While other analysts downplay the significance of this reported gold hoarding citing that China has been buying up almost everything from US treasuries, US equities to other commodities, we believe that China seems to be positioning its currency, the yuan, as a candidate to replace the US dollar as the world’s reserve currency as discussed in Phisix: The Case For A Bull Run or possibly working to provide an insurance cover on its currency against the growing risks of hyperinflation, which would translate to massive losses in its US dollar holdings on its portfolio [see Has China Begun Preparing For The Crack-Up Boom?].

In presaging for times of trouble, commodities essentially could function as the yuan’s potential “anchor”.

It makes no fundamental sense to excessively store up on gold, other metals, oil and other commodities unless severe shortages have been perceived as a potential problem.

As a political institution, China won’t be much concerned with the “convenience yield” or “the benefit or premium associated with holding an underlying product or physical good, rather than the contract or derivative product” (answers.com), even as commodities don’t generate interest income which is offered by financial assets.

Besides what’s the point of disclosing the sharp increase in gold reserves by China after 5 years of covert accumulation operations?

Thus, China’s actions can be construed as essentially more politically motivated (timed with its bleating over the increased risks of the US dollar) with economic and financial ramifications.

The other point is NOT to look at China’s holdings of US dollar assets on an absolute level but from a relative standpoint: where has China’s concentration of US assets been-in long term or short term securities? Remember although China may continue to buy US securities in order to hold its currency down, if it does so by accumulating assets in mostly short term duration, then this may be extrapolated as an attempt too reduce its currency risks exposure.

Finally, despite the ongoing official manipulations gold market isn’t just an issue for central banks as private institutions have been feverishly accumulating on gold holdings as seen in Figure 2.

Figure 2: Casey Research: Gold ETFs are rapidly catching up with top Central Banks

According to Casey Research, ``SPDR Gold Shares (GLD), an exchange-traded fund, first hit the market in November 2004 with 260,000 ounces of gold. Today, GLD is the world’s 6th largest holder of physical gold with over 35 million troy ounces in the vault. In fact, since the general market meltdown last fall, the ETF has added over 16 million ounces and ended 2008 with a 5% gain – not many investments can make that claim. Investors worldwide are sending a clear message: Gold is the safest asset in which to store wealth, not the product of the printing press.”

So even when official institutions have been attempting to control the gold markets, the interest from private investors have been strongly accelerating to possibly offset any substantial sales by top gold holders.

As Professor Gary North notes, ``Eventually, governments will run out of gold to sell, and so will the IMF. They will run out of gold to lease. While I do not think the politicians will ever catch on to the fact that their nations' gold is gone, leaving only IOUs for gold written by bullion banks that are on the verge of bankruptcy anyway, I do think that at some point the central banks will stop leasing gold.”

In short, once a substantial segment of gold from official institutions has been transferred to the investing public, governments will lose their power to manipulate gold prices.

Moreover, the relative variances in the holdings of the gold reserves among central banks underpins a possible realignment of gold distribution from crisis affected US and European nations with present heavy gold holdings to the savings and foreign currency reserve rich emerging economies.

So the potential shift likewise favors rising gold prices.

3. Ignores Seasonality Effects of Gold

Those bewailing fear have likewise been guilty of the omission of the seasonality patterns of gold see figure 3.

Figure 3: US Global Investors: Seasonal Patterns

The chart from US Global Investors manifests of the 15 and 30 year pattern of gold.

Basically, the annual trend can be identified starting with Gold’s summit during the first quarter which effectively goes downhill until the early third quarter where it bottoms, strengthens and ascends.

Even if we were to compare the movements over the last 3 years in Figure 1, the seasonality effects almost seem like clockwork but not in exactitude.

So if I were a gold trader, I’d start accumulating the benchmark precious metal during the lowest seasonal risk months of July to September and be a seller at the start of the year. Although in the interim, I should expect gold to firm up going into May where I should expect a summit and weaken into July or August.

Of course the seasonality factors have divergent depth or heights in terms of losses and gains mostly depending on the underlying long term trend. However in the present bullmarket, instead of correcting during the seasonal low months gold could simply consolidate (similar to 2007).

The point is if we understand and become cognizant of gold’s seasonality patterns, we won’t be lulled to the oversimplified anchoring of ascribing “fear” on gold prices.

Although as a caveat, considering that in the past 15-30 years gold’s annual cycle has been predicated on the demand configuration centered on mainly Jewelry (as I have shown in a chart last February), the accelerating interests on identifiable investments could diminish the seasonality effect variable.

4. Neglects the Risks of Accelerated Inflation Due To Flawed Economic Principles

Most believers of the “Fear” in gold see the risks of deflation more than the risks of inflation. That’s because they live in a simple world of known variables such as “liquidity traps”, “aggregate demands”, “animal spirits”, “current account imbalances” and “overcapacity”. On the same plane, they believe in the “neutrality” of money.

Let me remind you that the fundamental reason global governments are inflating have been due to the perceived risks of deflation, or said differently, for as long as the perceived risks of deflation is in the horizon, governments will continue to inflate, as they have been practicing what can be described as their ideology or textbook orientation-where policymaking or the decisions of a few is reckoned as better than the decisions of the billions of people operating in the marketplace.

As you can see, the irony here is that governments essentially FEAR falling prices in everything. Where falling prices are good for the individual (as it translates to more purchasing power), they are deemed bad for the society, so it is held.

And the same applies to savings; “savings” defeat consumption, so it is held, as reduced consumption equates to diminished “demand” which is equally bad for the society. Hence, to counter falling prices, means that governments and their coterie of mainstream supporters exalt on the furtherance of borrowing, spending and speculative inducing policies, the very policies that brought us this crisis.

Unfortunately the US and European banking system remains fragile as governments have kept alive institutions that needs to expire. The losses have now escalated to a sink hole-some $4.1 trillion of toxic assets, according to the revised estimates of the IMF. This means more redistributive processes is in the offing given this ideological framework, where more money especially from crisis affected nations will be used to prop up zombie institutions. The US has pledged or guaranteed a stupendous $12.8 trillion and growing (as of March 31), while UK’s support for its financial industry has already surged to a remarkable $2 trillion and counting.

Apart, every nation have been urged to do their role of printing money, borrowing and spending from which global policymakers have gladly obliged. The local crocs have been jumping with glee as Philippine stimulus spending of Php 330 billion or ($7 billion) translates to a surge in “S.O.P” (Standard Operating Procedure or other term for kickbacks).

The unfortunate part is that not every country or region has been affected by an impaired banking system. Emerging markets have primarily been affected by the transmission mechanism of the US epicenter crisis via external linkages of trade (falling exports), labor (reduced remittances) and investments. Hence, the deflationary pressures seen in nations which presently endure from busted credit bubbles and emerging markets suffering from sharp external adjustments or two distinct diseases have been administered with similar medication but in varying dosages.

Apparently, since money, for us, has relative impact on prices, these concerted government sponsored programs has begun to ‘leak out’ to the marketplace-through stock markets first then commodities next, as expected.

The recently published World Economic Outlook from the IMF gave me an eye popping jolt over the very compelling fundamentals of food!

Thus, we’d deviate from gold and discuss about food. See figure 4.

Figure 4: IMF’s WEO: Supply side dynamics for select Food

According to the WEO (p.55) , ``In the face of weaker demand from emerging economies, reduced biofuel production with declining gasoline demand, falling energy prices, and insufficient financing amid tightened credit conditions, farmers across the globe have reportedly reduced acreage and fertilizer use. For example, the U.S. Department of Agriculture projects that the combined area planted for the country’s eight major crops will decline by 2.8 percent (year over year) during the 2009–10 crop year. At the same time, stocks of key food staples, including wheat, are still at relatively low levels. These supply factors should partly offset downward pressure from weak demand during the downturn.” (bold underscore mine)

Did you see spot the fun part in the chart? Notice that the inventory cover for the world’s major Food crops (middle) has been nearly at the lowest levels since 1989!

Despite the surge in Food prices in early 2007 these hasn’t translated to a boom in the production side. Now that the crisis has been the underlying theme which has also impacted the food industry, production has further been impeded by “tightened credit conditions” which has “reduced acreage and fertilizer use”. Whereas consumption demand is expected by the WEO to be maintained at present levels (yellow line middle chart).

Remember the shelf life for food is short. Hence, surpluses are likely to be minimal.

Moreover, we have a looming structural long term demand-supply imbalance.

According to Earth Policy, ``Demand side trends include the addition of more than 70 million people to the global population each year, 4 billion people moving up the food chain--consuming more grain-intensive meat, milk, and eggs--and the massive diversion of U.S. grain to fuel ethanol distilleries. On the supply side, the trends include falling water tables, eroding soils, and rising temperatures. Higher temperatures lower grain yields. They also melt the glaciers in the Himalayas and on the Tibetan plateau whose ice melt sustains the major rivers and irrigation systems of China and India during the dry seasons.”

What is this implies is that this episode of intensive money printing on a global scale will have a tremendous impact on food prices!!! If the boom in financial markets in emerging markets does extrapolate to “reflation” then there will be a tidal wave of demand to be met by insufficient supplies!! The next crisis may even be a food crisis!

In addition, the inelasticity or poor or lagged response from the price action, possibly due to overregulation, subsidies, import tariffs, etc… , suggests of a prolonged supply side response; as I earlier noted -the boom in food prices in 2007 didn’t translate to a meaningful supply side adjustment.

So those obsessing over the “deflation” bogeyman will most likely be surprised by a sudden surge of Consumer Price Index especially when food prices hit the ceiling.

This is equally bullish for gold.

Moreover, for governments and those fearing deflation who are in support of policies operated by the printing press, it seems to be a case of “be careful of what you wish for!”