Please, click here to read this article in pdf format: july-25-2011
Two weeks ago, we wrote that we had bought gold during its sell-off on June 30th /July 1st . We did so reluctantly. and sold it at the close of Friday 15th, consciously against that basic trading rule that says that one has to let profits ride. In perspective, during last week, our proceeds now invested in Canadian dollars made more sense than the oscillation of gold between $1585-$1,605/oz. As we write, we do so on the contrarian side, telling ourselves that it is always better to be out wishing to be in, than to be in, wishing to be out.
We are contrarian because it is hard for us to see gold making higher highs…and yet it does. What is the reason for our position? If prior to August 2nd we have a deal regarding the debt ceiling in the US, gold in our opinion would have to correct, given the reduction in jump to default risk. If we do not have a deal and we face a downgrade or default on US sovereign debt, we think that the world will face a serious run for US dollar liquidity. This, as counterintuitive as it sounds, would appreciate the US dollar, for as long as it takes the Fed to intervene, launching a forced QE3 (debt monetization), whereby downgraded/defaulted debt is purchased. Nobody can honestly quantify this scenario, but from the moment it is triggered to the moment the Fed steps in, we would see assets, among which gold stands as one, selling off. Therefore, we remain on the sidelines, nervous and fighting our greed.
On another note, today we want to write about an issue that is in our opinion the main root of the problems the world faces today: Dogma. We will take here Wikipedia’s heretic definition of “Dogma”:“…Dogma is the established belief or doctrine held by a religion, or by extension by some other group or organization. It is authoritative and not to be disputed, doubted, or diverged from, by the practitioner or believers…”
We think that the world is in trouble today because leaders believe in the following dogmas:
-The existence of an “output gap”
This dogma is nothing else but the complete dismissal of the price system as the most effective tool man has to allocate resources. An output gap is the difference between what is called potential output and real output. What do mainstream economists think a potential output is? Do they think that resource allocation is whimsical? Have they ever stopped to think why is it that entrepreneurs/firms decide to produce less? Obviously not. The answer is simple: To remain profitable. Central bankers lowering interest rates to address this gap is no different than Robert Mugabe’s decision to confiscate farms from farmers who whimsically choose not to increase their output. It leads nowhere and only further complicates things. There is no gap because there is no “potential” output. This is a mechanistic view that if taken to the extreme, should lead us to conclude we should be working all the hours that we do not use to sleep or eat.
-Inflation can be targeted
This dogma is based on another one: The belief that the expansion of money and credit is neutral, which means that it has no effects on relative prices or the structure of production within an economy. If this was correct, it would make sense to keep creating money and credit until the output gap is “closed”. But such creation involves a process where relative prices are seriously changed, affecting production and the relative allocation of resources.
-Well capitalized financial institutions can resist a run for liquidity
This dogma is currently very much in fashion, with Basel I, II and III and why not IV? It is based on the denial that fractional reserve constitutes a fraud. If it is not, we should not believe that financial institutions will face a run. If it is not, all we have to care about is that the expected losses resulting from the investment decisions of these institutions are consistent with their capital. Of course, these investment losses are considered to be random, not the generalized result of a misallocation process, triggered by the expansion of credit and money.
And the last one…”Gold is not money”, as sustained by Ben Bernanke, when asked by Congressman Ron Paul. We leave it to the reader. Here is the Youtube link to it: http://youtu.be/2Dj9v9s9buk
There are more dogmatic beliefs, but we think they are all simply extrapolations of the ones described above. One of these extrapolations, for instance, is the belief that under a system with a central bank and fractional reserve, one should pay a premium (i.e. lower return) to diversify his/her portfolio (i.e. lower risk). This belief is the natural outcome of the dogma of the existence of a risk-free asset (US treasuries).
Unlike the times of Aristarchus of Samos or Nicolaus Copernicus, ours has the fortune of already counting with a diversity of economists/journalists/politicians (mostly from the Austrian school), who can champion the scientific challenge of the dogmas above and communicate it through the Internet. We should therefore be optimistic.
Martin Sibileau
The comments expressed in this website and daily letters are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer or its affiliates. All comments are based upon my current knowledge and my own personal experiences. You should conduct independent research to verify the validity of any statements made in this website before basing any decisions upon those statements. In addition, any views or opinions expressed by visitors to this website are theirs and do not necessarily reflect mine. My comments provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, and contracts for differences). My comments are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.
Through our past letters we have turned more and more negative, we acknowledge. We’ll go through a quick summary of our thoughts since the beginning of the year:
We had been optimistic until March, hoping that the European Financial Stability Facility would be used to buy sovereign debt from EU peripherals in the secondary market. That alternative was dismissed and since then, the Euro zone has been following the path of typical currency crisis under convertibility.
In the meantime, emerging markets (creditor nations) have been fighting the inflation they consciously imported from the developed world, attacking the symptoms, rather than the root. The root was and is their monetary policies, which seek to prevent their respective currencies from appreciating (by buying FX reserves): The symptoms are higher balances in their respective banks, ready to fuel more consumption. They will continue the attack by limiting capital inflows in volume and in price (with taxes), increasing the banks reserve requirement ratios, capital or cost of funding.
In the US, we have and continue to witness a deterioration in the employment and activity indicators. Mainstream economists will point that this is in spite of the billions of fiscal debt being monetized, with QE1 and QE2. We, however, will say that this is occurring because of the billions of fiscal debt being monetized, with QE1 and QE2. Along this line of reasoning too, we wrote in our last letter: “…we see the relationship between cause and effect differently: We don’t see future higher oil prices driving energy stocks higher in the long term. On the contrary, because interventionism is destroying wealth, lowering asset valuations (i.e. stocks), production will be affected and the lower supply will push prices higher…”. We stand by this concept and today we show a chart (source: Bloomberg), which we fear may be signaling a nascent trend:
In the chart above, we compare the price of oil (orange) vs. the S&P TSX Energy index (white), for the period starting June 24th, 2011, the day after the International Energy Agency surprised the world with the announcement that 60MM barrels of oil would be released. The price of oil has outperformed the rise in value of energy stocks, 5.7% to 4.7%. We fear this trend, which is characteristic of stagflation, may further develop, where it is better to buy the product than the means of production. Usually, the equity of the companies that produce commodities constitutes a leveraged way to bet on the price of such commodities: If we think the price oil will increase, we may buy energy stocks to earn a meaningful profit from that increase. If we think the price will decrease, we may short those energy stocks for the same reason. But under stagflation, that is no longer the case, particularly when the inflationary process spirals. We will be paying attention to this relationship.
Lastly, two weeks ago, we had warned that the price of gold would be challenged and that we preferred liquidity. We still believe gold will have a tough time going forward, but with the threat of Moody’s to downgrade Italian banks, the fear of risk contagion throughout the Eurozone began to spread (and was later confirmed with Portugal’s downgrade). Accordingly, during the sell-off on June 30th /July 1st, we had no choice but to get long of gold again. We will sit tight now.
Martin Sibileau
The comments expressed in this website and daily letters are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer or its affiliates. All comments are based upon my current knowledge and my own personal experiences. You should conduct independent research to verify the validity of any statements made in this website before basing any decisions upon those statements. In addition, any views or opinions expressed by visitors to this website are theirs and do not necessarily reflect mine. My comments provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, and contracts for differences). My comments are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.