February 2010

What relevance does this question have to the financial markets? Possibly not a great deal. However it was a discussion that was taking place elsewhere in blogoland and the level of discussion was so low that I was quite astounded. To cut a long story short, the evidence, proofs, and other argument all centred around religion and the study of the Bible.

This particular question has preoccupied some of the best minds in history. The way they approached the question was in the following manner.

*A reality that transcends time and space
*The ground of being and value
*A reality worthy of man’s worship

Notice that God is not defined as a being, rather, as a reality. The reason is that a being connotes a something existing in spatiotemporal understanding, alongside other spatiotemporal somethings. Philosophers who have believed that God exists, and that his existence could be proved, have not intended to assert the existence of a being occupying some particular region of time-space. They have meant to assert, rather, the existence of a reality that is not subject to these categories. Hence, God is not a being, but a reality.

The term ground, has been employed by Philosophers when talking about cause. A cause is a spatiotemporal something, that stands in a certain relation to something else that is called it’s effect. As God, a reality, stands outside of spatiotemporal consideration, so ground is adopted in place of cause.

There have been five primary arguments put forward in relation to proofs in support of God’s existence:

*Religious Experience

The first two carry the majority of the intellectual firepower, with the moral argument tending to support the first two, rather than creating a new a separate line of reasoning. I shall be looking at, and analysing the first two arguments, the first, comes from St Anslem.

Nothing terribly exciting taking place, lots of patience required.

Just popped over to iBC…and no ChartAddict blog. Gone. Has flippe-floppe-flye sacked him? Possibly someone in blogoland knows the answer to this rather perplexing mystery. Do tell!

Frenzied developers with access to cheap money are creating a glut of premium office space and luxury apartments, priced at about 80 times the average income of the city’s residents. Prospective middle-class homeowners, in panic-buying mode, are snapping up two properties at once, hoping to flip the second one to finance the first. Civic officials are encouraging the building boom.

The sale of vacant lots bolster their municipal coffers.

Banks eager to reap upfront fees are granting mortgages to all comers. Even factory owners are in on the speculation, generating more profit from flipping property than from traditional manufacturing, which increasingly is moving offshore to Vietnam, Malaysia and other nations with lower labour costs.

No, this isn’t Toronto in the late 1980s, or Santa Barbara or Tallahassee six years ago at the height of America’s record housing boom, which culminated in a global credit crisis and ensuing recession.

This is Beijing today, where until recently one of the most popular programs on local television was a reality show called The Romance of Housing that spotlighted the struggles of families pursuing elusive affordable shelter.

And where the papers are reporting on suicides and violent protests after developers in cahoots with local officials seize someone’s land for a new office building or apartment block.

The disturbing phenomenon extends beyond Beijing, where housing prices are far higher than in Dubai’s overbuilt property market before that red-hot Persian Gulf economy imploded last year. In December alone, Chinese housing prices rose almost 8 per cent in 70 major Chinese cities, while housing starts leapt by 34 per cent nationwide.

Jim Chanos, the legendary U.S. short-seller who thrives on post-bubble bargain-hunting, claims the overheated Chinese housing market is “Dubai times 1,000 — or worse.”

Chanos has an obvious stake in chaos. Not so Patrick Chovanec, as associate professor at the business school at Beijing’s Tsinghua University. Chovanec cites the intoxicating impact of Beijing’s $586-billion (U.S.) stimulus package and an additional $1.4 trillion in lending by state-controlled banks to real estate and other industries last year alone.

With easy money in such abundance, it’s no wonder developers are on a building jag.

“You have state-owned enterprises using borrowed funds from the stimulus bidding up the price of land in Beijing — not even desirable plots of land — to astronomical rates,” Chovanec told Bloomberg News last week.

“At the same time, you have 30 per cent-plus vacancy rates and slumping rents in commercial property. So it’s just a case of when (lenders] recognize the losses — or don’t.”

For the moment, there are two Chinese property markets. There’s an over-served premium-priced office and luxury apartment sector, and a neglected affordable housing market so underserved for lack of profit margins that Beijing recently pledged on its own to build 15 million units of shelter for low-income people.

Limited though the boom is to the high end of the market, the stupendous sums tied up in it have the potential to impede, if not halt, China’s fast-track Industrial Revolution when the boom inevitably ends.

“It’s simply a matter of time before the Chinese real estate bubble bursts,” insists Yi Xianrong, longtime student of Chinese property trends at the finance department of the Chinese Academy of Social Sciences. “A bubble burst in China would not only deal a fatal blow to our own economy, but would also extinguish the world’s hope for recovery.”

Indeed, Western economies are counting heavily on China to lead the nascent global recovery. China’s projected GDP growth this year of about 9.5 per cent will account for about one-third of global economic growth this year.

China has been providing one of the bright spots in the recent global downturn.

Bankruptcy victim General Motors has lost money in North America and Europe for years, but it profits from booming Chinese sales.

And Paul Otelli, CEO of California-based Intel Corp., the world’s leading computer-chip maker, recently said, “Thank God for China. It buoyed our company through the depths” of the recent global downturn.

China has just overtaken Germany as the world’s largest export economy, and eclipsed the U.S. as the biggest vehicle market.

Wen Jiaboa, the Chinese premier, has acknowledged that “property values have risen too quickly,” and vowed a crackdown on speculators. China’s central bank has twice this month raised the amount of capital Chinese banks must hold in reserve to cover losses, reducing funds available for property loans. But government officials are in a quandary over how hard to apply the brakes. A sudden about-face in Beijing’s easy-money policy of ultralow interest rates could trigger widespread property devaluations that would hit not only homeowners but also construction, finance, steel, furniture and other sectors tied to the real estate market.

Yet the longer the bubble persists, the more punishing the inevitable implosion, as Western economies learned from the collapse of the U.S. housing market in 2007-08.

So, uncertainty rules.

A soft landing can be engineered if China’s recent, modest steps to cool the market send a powerful enough signal to developers and panic buyers — and provide enough time for a rise in average income levels to match exorbitant housing prices.

In the meantime, there are a few signs the mania is exhausting itself. The new “instant city” of skyscrapers and thousands of villas built in the coal city of Ordos in China’s Inner Mongolia is largely vacant — a sobering sign to overzealous developers.

“Who would go there?” a downtown resident told Bloomberg Business Week recently of the sprawling metropolis taking shape in the nearby suburban desert. “It’s a city of empty buildings.”

The Romance of Housing show was yanked from the air in November, ostensibly because state officials were offended by a scene depicting a corrupt state official. But the show more likely got the hook over concerns that it celebrated recklessness with personal finances. And in Beijing, dirt is accumulating around the entrances to the newly built twin-tower head office complex of the Bank of Communications Co.

In a business district with a 35 per cent vacancy rate due to over-exuberant developer activity, the lobby of the BCC landmark is now used as a bicycle parking lot.

By Marshall Auerback, a fund manager and investment strategist who writes for New Deal 2.0 and Yves Smith

Conventional wisdom holds that the Chinese are due (as in overdue) for a revaluation of their currency, the renminbi. For instance, a recent report from Goldman argues that China will raise the value of the RMB against the dollar by 5% this year. The argument is that the move is needed to slow down an overheating economy.

But to a large degree, whether you agree with that as a remedy depends on what one’s reading is not just of China’s notoriously misleading statistics, but of the underlying growth dynamics, which are well out of bounds of any previous pattern, and not in a good way, either.

We question whether a revaluation is the right answer for them, and more important, whether the Chinese themselves see a revaluation as a plus. The government has engineered an enormous increase in money and credit in the past year. In fact, it seems to be as great as 5 years’ growth in credit in the previous Chinese bubble. The increase in money and credit is so great and so abrupt that you tend to get a high inflation quite quickly even if there are under utilised resources. Add to this the fact that China simultaneously is providing massive fiscal stimulus.

This combination is the making of a very messy situation. If China seeks to sustain demand via fiscal policy, the result is likely to be a big inflation problem. With many Chinese students steeped in Chicago School monetary theory coming home and assuming positions of authority, they could push for an aggressive, Paul Volcker-style effort to stop inflation.

But, what if the they don’t? Inflation can take off and thereby begin to ERODE the competitiveness of Chinese exports. Nouriel Roubini pointed out this issue in 2007: if China didn’t revalue, inflation would do the trick regardless. A continued high rate of inflation relative to its trade partners would push up the price of goods in home currency terms, which in turn translates into higher export prices. This might be the real reason why China is so reticent to revalue its currency. The Americans might go crazy if the Chinese devalued, but if the inflation is high enough, they might have to do it, as it will severely erode their terms of trade and cause their tradeables sector to collapse.

Or the hard-line monetarists triumphing by fighting inflation and the result is riots as unemployment increases.

It could get very ugly.

This could be happening now in China, although this is the opposite of prevailing views. The consensus is that inflation is a couple per cent and even that is largely due to higher pork prices thanks to a lousy corn harvest.

However, economists such as those at Lombard Street in the UK, Jim Walker, Simon Hunt and the like try to figure out the changes quarter to quarter in Chinese nominal GDP which is reported only year on year. And they come up with giant double digit growth rates for the second half of last year.

Now this is complicated by the fact that the Chinese have revised up their GDP numbers and they put all the revisions into the final quarter of the year. But when these analysts try to adjust for that statistical screw up they still come up with giant nominal GDP increases. Lombard Street thinks it was twenty five per cent or so in the second half of last year. They think it was twenty per cent real and five per cent inflation.

Economies of any size never grow at a twenty per cent real rate. And Simon Hunt says if you look at proxies like power output and rail traffic you don’t get those kinds of numbers for real growth, which suggests that inflation must be higher than four or five per cent. In general, if a real GDP figure looks sus, the first figure you examine critically is the GDP deflator.

So some evidence suggests that China’s inflation could already be at a double digit level. It is hard to say. But if it is that high, then the resultant inflation will cause a real revaluation of the trade weighted exchange rate.

And more so if the dollar rallies. That could well crush the volume of exports and the profitability of the industrial tradeables sector. Exports are the only area where China makes any kind of money because they can sell these products for about 10 times what they obtain for a comparable product in the domestic economy (where profits are virtually nil). The export sector is a big contributor to overall super excessive fixed investment in China. Dollar appreaciation means foreign direct investment will go to zero net.

There will be strong forces for a reduction in fixed investment in this large sector. Hence, there is a good chance that even without monetary tightening by the Chinese authorities, the overall fixed investment boom in China will turn down.

Nobody is thinking about this scenario but it is a real possibility. And with fixed investment now at fifty per cent of GDP (which is unprecedented in any economy) and exports at more than thirty, we’re looking at ratios that have never been reached before on a combined basis. Before readers argue that China can support that level of investment, consider the views of Professor Yu Yongding, who some analysts believe is China’s best macroeconomist. As reported in the Sydney Morning Herald:

Yu, the recently retired director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, did not explicitly say I was barking mad. But his email continued: “When a country has an investment rate over 50 per cent [of] GDP and rising, you say this country is not suffering from overcapacity! … are you serious? ”To judge whether there is overcapacity you cannot just do a head account. With a 1.3 billion population and human greed, China’s needs are unlimited, you can say that China will never suffer from overcapacity!”

The email noted that, on my logic, no developing country could ever suffer from overcapacity until it became rich and that the world should never have suffered a Great Depression in 1929.

Since that salutary critique, Yu has elaborated further on his views.

He believes China is trapped in a cycle where constantly rising growth in investment is constantly increasing China’s supply, but consumption has conspicuously failed to grow fast enough to absorb it. And so China is forced to increase investment in order to provide enough demand to absorb the previous round of increased supply, thus creating ever-widening cycles of oversupply.

In this manner, the investment share of gross domestic product has increased from a quarter of GDP in 2001 to at least half. “There is sort of a chase – demand chasing supply and then more demand is needed to chase more supply,” he says. “This is of course an unsustainable process.”

From 2005 China’s overcapacity problem had been “concealed” by ever-increasing net exports – but that strategy was interrupted by the financial crisis. Then came last year’s globally unprecedented stimulus-investment binge, which might not have been so worrying if it were delivering things that people needed. But the Government’s hand in resource allocation has grown heavier since the crisis without reforms to make officials more responsible for what they spend.

“As a result of the institutional arrangements in China, local governments have an insatiable appetite for grandiose investment projects and sub-optimal allocation of resources,” as Yu previously said, in his Richard Snape lecture for the Productivity Commission in November.

So there are now airports without towns, highways and high-speed railways running parallel, and towns where peasants are building houses for no reason other than to tear them down again because they know that will earn them more compensation when the local government inevitably appropriates their land.

Reducing investment and exports could create a severe recession in China. China has gone too far this time. They appear to be in a box that they and others don’t recognize. The “Black Swan” event this year, as far as China true believers are concerned, could well be a devaluation of the RMB. Were that to happen, the political consequences could be as significant as the economic.

With fourth-quarter earnings largely in the books (over 79% of S&P 500 companies have reported for Q4 2009), today’s chart provides some long-term perspective to the current earnings environment by focusing on 12-month, as reported S&P 500 earnings.

Today’s chart illustrates how earnings declined over 92% from its Q3 2007 peak to Q1 2009 low — the largest decline on record (the data goes back to 1936). Since its Q1 2009 low, S&P 500 earnings have surged (up over 600%) and currently come in at a level that has only been exceeded during the latter years of the dot-com and credit bubbles.

So earnings have bounced back. The unprecedented stimulus via Monetary policy and Fiscal policy has essentially pumped the earnings back up. A large component of this will be the financial sector, the banks, who will have gone from making record losses, back to profitability, thank’s to the interest rate spread and Bernanke paying interest on Reserves.

Obviously the P/E ratio of the overall market will now start to look pretty attractive, which will encourage investors who do not look to far below the surface at the quality of those earnings.

An Address at CARA Bahamas Conference. Freeport, Grand Bahama. Januray 17, 2010
by Antal E. Fekete,
Professor of Money and Banking
San Francisco School of Economics
February 19, 2010

Ladies and Gentlemen:

The cliché that the present credit collapse is “the greatest financial crisis since 1929” is the understatement of the century. One measure of the crises is the ratio of gross private debt to nominal GDP. This ratio captures the idea how many years of current output it would take to retire outstanding debt. In these terms, the crisis is truly unprecedented. The world plunged into the present crisis with far greater debt than the debt outstanding at the time when it plunged into the Great Depression in 1929. Add to this the qualitative change in the structure of debt. The most exotic of the Roaring Twenties era debt was brokers’ margin lending on the stock purchases of clients. Today, in addition, we have: (1) derivative instruments valued up to one quadrillion dollars, (2) adjustable-rate mortgages, (3) the unquantifiable off-balance-sheet activities of financial institutions, and (4) the junk-bond activities of private equity firms. The unwinding, or should I say unravelling, of this financial esoterica will greatly increase the underlying debt. The momentum of change in the debt-tower will insure that debt ― and bankruptcies ― will continue to rise even as the economy contracts.

The greatest amplifier of the debt burden: falling interest rates

I won’t beat around the bush and say it without hesitation that the greatest underlying cause of the present crisis is the ongoing destruction of capital induced by the falling interest-rate structure. Economists and accountants are still blind to the fact that falling interest rates amplify the burden of debt. According to Fischer’s Paradox: “The more debtors pay, the more they owe”. In this single sentence we have the essence of deflation. Payments of the debtors are discounted at the lower current rate of interest ― not at the higher rate at which the debt was originally contracted!

This may be the nightmare that keeps Ben Bernanke awake and his printing presses in high gear. All in vain: falling prices defy the printing presses. Last year the fall in CPI was the steepest since 1932 at 2 percent. Forget monetarism, forget the Quantity Theory of Money. Forget Friedman. Call it Fekete’s Paradox if you will: “The more the Fed tries to pump up commodity prices with its printing presses, the more they will fall”. The explanation of this paradox is found in the contrarian behavior of the speculators. Yes, they will snap up the newly printed dollars and run with them. But run they will in the wrong direction. They run not to the commodity market as hoped by Bernanke, but to the bill market where the fun is. They front-run Bernanke and his team. They effectively corner the market for T-bills before Bernanke can buy his quota, without which he cannot print more dollars. Then speculators turn around and feed the T-bills to the Fed on their own terms. Thus the Fed’s effort to induce inflation will fail ― just as the effort of the Bank of Japan to pump up prices was a dismal failure in 2002.

Greenspan surfing the tsunamis

In a testimony to Congress Alan Greenspan has described the financial crisis as a “once-in-a-century credit tsunami”. His simile is as misleading as it is inappropriate, on at least two counts. First, geologists do understand the cause of a tsunami; Greenspan and other policy-makers do not understand why the global financial crisis has occurred. Second, while geologists understand tsunamis, they do not cause them. In contrast, policies implemented at the Fed and at the Treasury are directly responsible for the financial tsunami. Worse still, policy-makers fight the destructive effects of the tsunami with means that can only be described as counter-productive. They make the crisis worse, not better.

They had encouraged a debt-financed speculative bubble in asset prices that created a 25-year illusory prosperity but was doomed to burst, ushering in a self-aggravating economic downturn. They are utterly ignorant about the role of capital and debt in the productive process. They believe that credit can replace capital, so that capital destruction can be repaired with more credit expansion. The vast majority of their colleagues at the universities are not any better informed, either.

Gold as the ultimate extinguisher of debt

If we accept the thesis that exorbitant debt and the destruction of capital is at the root of the present crisis, then we’ll be directed to the solution of the problem. The solution is gold. The reason why there can be no resolution of the crisis without gold is two-fold.

(1) Gold is the only form of capital that is immune to destruction under any circumstances.

(2) Gold is the only ultimate extinguisher of debt.

I shall deal with the first reason in a moment. Here I just point out that when a debtor repays his debt by handing over Federal Reserve notes to his creditor, the debt is not extinguished. It is merely transferred to the Federal Reserve bank that issued the note. Transferring debt is not the same as extinguishing it. One reason for the present plight of the world is that for the past forty years gold, the only ultimate extinguisher of debt, has been forcibly prevented by the U.S. government to discharge its debt-extinguishing function. As a consequence the debt-tower has kept growing, rain or shine. Conversely, until policy-makers at the Fed and the Treasury will understand that there is no substitute for gold in taming the debt-monster, their tinkering at the edges will keep making the global debt crisis worse.

Unfortunately, the news is not good in this regard. Bernanke is a dyed-in-the-wool chrysophobe. He would hardly be competent to make the necessary changes that would restore gold as the ultimate extinguisher of debt in the international monetary system.

Here I come to the point of my talk. What can the individual investor do to make sure that his investments will not be completely wiped out in the coming financial Armageddon?

Gold as the only form of capital that cannot be destroyed

In wartime capital destruction normally presents itself as physical destruction of plant, equipment, and products at various stages of production. By contrast, in peacetime, capital destruction takes place on paper, through the consolidation of balance sheets. Take the simplest case when a bankrupt economic entity is overtaken by another in order to save whatever can be saved. Clearly, that part of the assets of the latter that have a counterpart in the liabilities of the former cannot be saved. It will be wiped out.

It follows that no asset that also occurs as liability in the balance sheet of a counter-party is safe against destruction through consolidation ― even if that counter-party is the government. We must remember that every government experiment with irredeemable currency in history has been an abysmal failure.

In the extreme case, when the balance sheets of all economic entities are consolidated in a holocaust, and all paper assets are wiped out, gold is always a survivor: the only asset that cannot be destroyed through inflation, through deflation, or through any other malady of the monetary system.

This means that gold, and only gold, qualifies as an instrument of hedging paper assets. Every investor owes it to himself to provide an adequate level of insurance against risks that prey upon the value of paper investments. But unless this insurance consists of physical gold held by the investor himself on his own premises, it will be ineffective.

Trading insurance makes no sense

This also shows that the attitude of most investors with regard to gold is faulty, not to say foolish. They keep talking about the “performance” of gold. They trade gold: buy it when they expect the gold price to rise; they sell it when they expect the gold price to fall. Many of them are finished with gold saying that “the bloom is off the roses”. This attitude is akin to that of the property-owner who thinks that he is saving money by cancelling his insurance coverage hoping to reinstate it later. It never occurs to him that it may not be possible to reinstate, if the external conditions change drastically.

The best policy concerning insurance is to buy it and “forget about it”. No regrets if the occasion to collect insurance compensation never arises. It is not a loss: it should be looked at as a gain.

A simple gold-accumulation plan, aiming at a gold hedge equivalent to 10-15 percent of net worth, with monthly additions will suffice, with the proviso that it is preferable to increase the hedge when the gold price is down.

Gold investors typically get nervous as they listen to rumors that the volatility in the price of gold indicates that the value of gold has become unstable. They forget that it is not gold that is unstable, but the dollar in which the gold price is quoted. Gold has been, is, and will be the paragon of stability. Ultimately, the price at which you have purchased your hedges is unimportant.

Tips for hedging

Buy anonymously and don’t talk about it. Don’t worry that you can’t sell anonymously: you are not going to sell, just like you are not going to cancel your fire insurance policy as long as you own the house. Don’t worry about capital gains taxes on your gold that you hold as hedges against paper assets. Since you never sell, you never incur a tax liability. There is no way the government can impose or collect taxes on paper profits. At any rate, those so called profits on your gold hedges should never be considered as profits. They should be looked at as advances on payments of insurance compensation for anticipated losses. It would be foolish to take these “profits” and spend them. Those losses may disappear, together with the gold profits, creating the impression that your hedges don’t work. They do, but the results have to be interpreted correctly. Spending gold profits is tantamount to cancelling the insurance policy prematurely. The big test is still ahead. The crisis is not over, not by a long shot.

The shape of things to come

The world lives in a delusion. It sets great stores on Keynesian nostrums, hoping that public debt-financed government spending, or inflating the money supply will resolve the crisis. They won’t. The first-mentioned Keynesian remedy will fail because replacing private debt with public debt means jumping from the frying pan into the fire. A true solution must reduce total debt. The second-mentioned Keynesian remedy will fail to induce the intended inflation because the newly created money just won’t go where the Fed would like it to go: to the commodity, real estate, and stock markets. Instead it will go to the bond market to facilitate bond speculation: borrowing short and lending long, putting a downward pressure on the yield curve. Alternatively, it will be used to retire private debt. In either case, the result will be deflationary, not inflationary.

As the decrease in debt reaches a threshold, it will have two immediate consequences. One: unemployment will skyrocket. Two: the financial system will self-destruct in a spectacular fire-work that will make the fact obvious to one and all. Concerning the first consequence, the U.S. must face the situation squarely that during the boom years it has dismantled much of its industrial park producing consumer goods for the mass market. It no longer has the factories needed to employ the armies of unemployed people that will be laid off in the financial sector: at brokerages, real estate agencies, insurance companies, not to mention banks.

Concerning the second consequence, it must be stated that the U.S. financial system is bankrupt already: it self-destructed during the long-drawn-out decline of interest rates to zero. This bankruptcy is camouflaged by the wholly misconceived measure of allowing the banks, pension funds and insurance companies to cook their books. They can only balance their books through the trick of overstating the value of their assets and understating the value of their liabilities. The government and the accounting profession are accomplices. Not only do they fail to prosecute violators of the accounting code, they even cheer them on and encourage others to do the same. Worst of all, they set the example. The Fed carries dead assets such as mortgage-backed bonds with no bid and no market at a positive value.

Revaluation of gold

The nation is lulled into a false sense of security. When the truth dawns on the nation that the American financial system is working without capital (following in the footsteps of the Japanese banks that have been brain-dead for over a decade), the shock will greatly aggravate the crisis. It would be better to let the truth come out now, so that the process of re-industrializing the country and recapitalizing the financial system by an appropriate revaluation of gold could start without delay.

The alternative to the revaluation of gold, seriously suggested by some respectable economists, is a complete debt-jubilee, that is, forgiving any and all dollar-denominated debt, starting with the government debt through mortgages and corporate debt, all the way down to the short-term liabilities of banks, including bank deposits. This is, of course, the ultimate shock-therapy with all the unknown consequences that it may bring with it in its train. Nobody knows how the unfairly dispossessed creditors, including all the pensioners and holders of life insurance policies will react. Nobody knows what the unjustly enriched debtors will do with their godsend, the transfer of unencumbered assets to their possession. Maybe bloodshed in the streets can be avoided. Maybe not. The still unsolved problem of unemployment strongly suggests the latter.

At any rate, why take the risk, when this dormant asset, gold, has been lying around fallow for some forty years and is waiting for rehabilitation. It has the two prerequisite properties that fit the need just like the glove fits the hand: the ultimate extinguisher of debt, and capital indestructible par excellence. With a proper revaluation of monetary gold, much of the existing debt-burden could be alleviated and new productive capital could be accumulated.

I am not suggesting that sufficient wisdom presently resides in the leadership of the world to see this. But as their false remedies will be tried, and one after the other will backfire, the ultimate solution to the crisis, gold-revaluation, would dawn on the world.

Let’s face it: the only reason why this plausible solution to the long-festering problem of runaway debt has not been applied already is sheer envy. Those who saw in gold only a “barbarous relic” would always look with envy at those who saw in gold the ultimate extinguisher of debt and the only indestructible form of capital. They would do everything in their power to deny the latter any benefit of their superior foresight.

From ZeroHedge

Assessing the fair value of gold largely remains a mystery in Finance. While in some instances the existing literature has found empirical relationships between gold prices and macroeconomic variables such as inflation and exchange rates, little evidence has been offered for connections between gold and other asset classes. To date, there is no comprehensive theory of gold valuation showing how inflation, exchange rates and other asset classes may together affect gold pricing; or how gold and other asset classes may be affected by common underlying factors.

In this paper, we offer a gold asset pricing theory that treats gold as a store of wealth. We demonstrate a theoretical and empirical link between gold price, inflation, and foreign exchange rates and the general valuation of the stock market. Our approach is based on a generalization of Required Yield Theory (Faugere-Van Erlach [2003]). Required Yield Theory explains the valuation of financial assets via investors’ general requirement to earn a minimum expected after-tax real return equal to long-term GDP/capita growth.

We hold that since gold fulfills the unique function of a global store of value, its yield must vary inversely to the yield required by any financial asset class, thus providing a hedge in the case where such assets are losing value. Our theory explains about 88% of actual $USD gold prices and 92% of actual gold returns on a quarterly basis, including the peak prices of gold, over the 1979-2002 period.

The extant literature has well documented empirical relationships between gold price and global macroeconomic variables such as inflation and currency exchange rates. For example, Sjaastad and Scacciavillani [1996] show that after excluding the sharp rise in gold prices in the early 1980’s, about half of the variance in $USD gold prices during the period 1982-1990 appears to be accounted for by fluctuation in real exchange rates. Ghosh, Levin et al. [2002] find that gold is mostly an inflation hedge in the long run. They further attempt to justify short-term gold price volatility by appealing for example to changes in the real interest rate and $USD vs. rest of the world exchange rates fluctuations.

On the other hand, the empirical record weighs heavily on the side that gold pricing apparently is related neither to GDP growth nor to other asset classes. Lawrence [2003] concludes that there is no statistically significant correlation between real returns on gold and changes in macroeconomic variables such as GDP, inflation and interest rates, and that the return on gold is less correlated with returns on equity and bond indices than are the returns of other commodities. Standing in contrast to the above findings, Coyne [1976] focuses primarily on gold as a hedging instrument and finds that for periods in which the gold market was free to fluctuate, gold tended to move in a direction opposite to the price of other financial assets.

Sherman [1983] makes a noted theoretical attempt at demystifying the pricing of gold. He uses a linear regression model to estimate elasticities of demand for gold. The key explanatory factors are exchange rates and unanticipated inflation proxies. While several useful relationships are studied, these relationships are assumed a-priori and not theoretically derived.

Barsky and Summers [1988] focus on the Gold Standard period and develop a general gold valuation model that views gold as a non-monetary durable good providing a stream of “consumption” services over time, like Jewelry or objects of art. They theoretically show a relationship between the inverse of the log of gold price and the real interest rate, which seems to hold empirically over the period 1974-1984. In their model, gold is a non-depreciable asset earning a yield equal to a government bond yield.

However, by rooting their model in the Gold Standard era, and extending their approach to the current era, they are not addressing the nature of Gold as a store of value, that is, a hedging instrument against inflation and the collapse of the value of other asset classes. In this paper, on the other hand, we undertake the analysis of gold along this exact line.

Throughout the history of civilization, gold has been the single most important global store of value. To this day, it fulfills this unique function. For the purpose of extending Required Yield Theory to gold pricing, we postulate the following: 1) The global real price of gold essentially is a real P/E ratio for gold, where “earnings” represent purchasing power or a global price index. 2) The global real price of gold must vary inversely to all other main financial asset classes’ real P/E to preserve the real value of any investor’s capital against adverse movements in the values of financial asset classes.2 3) Law of One Price: exchange rate fluctuations must impact local currency-denominated gold prices to eliminate potential international gold arbitrages. 4) Mining supply must be stable in relation to supply movements in the aboveground stock and the worldwide stock of gold per capita should not increase in the long run.

Condition 1) recognizes that even though gold does not produce actual earnings, its primary purpose is to provide a stream of services by maintaining real purchasing power over time. The same unit of gold can serve to purchase a representative basket of economic goods repeatedly. We define the forward P/E for gold as the price of gold divided by expected next period’s GDP deflator. It is easy to check that the real price of gold is the same as the real forward gold P/E ratio.3 Condition 2) insures that gold behaves as a store of value, that is: capital flows to gold are dictated by changes in the minimum expected return achievable by other asset classes. It is important to emphasize that gold per-se does not require the same yield as other assets, as it stands outside of the conventional realm of investment goals, and acts mostly as a global hedging tool against financial downturns, and inflation.

Hence, our theory postulates that movements in the global real price occur because of the precautionary demand for gold, which largely depends on changes in the inverse real P/E (or required yield) of other assets classes combined. A consequence of this postulate is that a decline in the value of the stock market index does not necessarily entail flight to gold when, for example, expected stock earnings are also falling to maintain a constant real P/E ratio. On the other hand, flight to gold will happen when stock market prices are dropping faster than expected earnings due to acceleration of inflation for example.

In addition, since gold is a global homogenous durable commodity its price must be equalized across countries after currency conversion, which is stated in condition 3). Finally, condition 4) states that the supply of gold must be stable so that investors’ precautionary motive is fulfilled without major price movements driven by supply shocks. Indeed this condition seems to be characteristic of the precious metal mining industry. Later on, we provide a formal argument that shows that this must be the case under our theory.

The total aboveground value of gold in the world is currently around $1.9 trillion at $380/Troy oz. ($380/Toz. x 32,150.7 Toz./Metric ton x 155,000 Mtons) compared with the approximately $15 trillion value of the US stock market and $22.4 trillion for US non-financial debt outstanding. Gold mining is a $31 billion per year industry with gold prices at $380/Toz. Given that the price volatility of gold is around 10% per year, it is easy to see why production companies heavily engage in hedging their future production. Ibbotson, Siegel and Love [1985] estimated that gold bullion represented 5% of total investable world wealth. Today, total world gold bullion represents 5.1% of the combined US stock and bond capitalization of $37.4 trillion; and a thus a much smaller proportion of total world wealth than the Ibbotson et al. study.

The rate of growth of gold extraction has essentially matched world population growth over the past 30 years. IMF data show that the more developed nations’ population grew a compounded 1.45% from 1972 – 2002, while total world population grew a compounded 1.89%. The global accumulated stock of gold grew from an estimated 98,000 tons in 1974 to 145,000 tons by mid-2001; implying a 1.46% growth rate. Thus, the world stock of gold per-capita has remained relatively stable over this period.

A preliminary empirical investigation of the price of gold reveals a non-trivial connection between real gold prices and the US stock market. Figure 1 below shows that gold’s real price varies inversely to the S&P 500 P/E, and thus with the earnings-to-price ratio. Figure 1 shows the high correlation between indexed USD real gold prices, inverse S&P 500 forward P/E ratio and 10-year T-Bond, over the period 1979-2002.

We have extended the Required Yield Theory (RYT) developed by Faugere-Van Erlach [2003] to value gold and to determine its return. RYT states that since global assets are priced to yield a global constant real return, and since gold is a global store of value, its price will vary directly with the global required yield and the global inflation rate. In the course of developing this asset valuation model we introduced a new exchange rule parity based on required yields comparisons across countries.

Specific predictions include: 1) the real price of gold varies proportionately to the change in long-term economic productivity as measured by GDP/capita growth. 2) Real gold prices vary proportionately to changes in the foreign exchange rate (direct quotation) when the domestic required yield is constant. 3) When the foreign exchange rate is constant and there are no major geopolitical or natural crises, real domestic gold price increases with domestic inflation. 4) When our new exchange rate parity rule holds, then effectively the real domestic price of gold is mostly determined by the domestic required yield. This entails that foreign exchange effects will impact the domestic real gold price to the extent that equalization of required yields is not taking place worldwide and/or that PPP is violated as well. 5) In the long-term, the gold per-capita supply remains constant. 6) The average long-term absolute price of gold is marked-up cost where the profit margin is given by the global average long-term per-capita rate of GDP growth.

While we suspect that central bank activities, hedging activities, supply/demand fluctuations, global real GDP growth changes or changes in global income and capital gains tax rates, affect gold prices as well, the valuation approach developed here performs very well absent these factors, with over 92% accuracy in predicting US Gold returns over a 23-year period. We leave an investigation of the role of these other factors for future research.

In the long run, the gold mining industry’s real profit margin is constant and equals the real per capita productivity. The price of gold, on average, must be the average production cost plus a constant mark-up. Furthermore, in order for the real value of gold to be maintained on a per investor basis, the stock of gold has to grow at a rate that can be no greater than population growth in the long-term. If the supply of gold grew at a lesser rate than population growth for reasons other than depletion of the exhaustible ore, gold price would grow faster than inflation and the quantity demanded for gold would drop. Eventually the supply of mined gold will dwindle, which will drive prices up unless world population experiences zero growth in the foreseeable future. In that circumstance, far off in the future, a substitute medium of storing value may be discovered and used.

Another prediction of our theory of gold pricing is that the decrease in proportion of gold total value as compared to world wealth is explained by RYT in the fact that relative to financial assets, the long-term nominal value of gold must increase at the inflation rate, whereas the value of other assets rise with inflation plus real productivity. Thus, the proportion of investable wealth declines at an annual rate equal to real per share earnings growth or GDP/capita growth.

ChartAddict back to his usual unsubstantiated, uninformed, anecdotal best form. There is so much rubbish here it will take a few posts to cover all the nonsense. It is however an enduring debate amongst traders, although predominantly novice ones.

I wanted to bring up the ongoing conflict among two schools of thought – fundamental analysis and technical analysis.

While this is probably true, the divisions are growing less and less. Enlightened traders tend to use elements from both methodologies.

A common question that needs to be answered is “Does technical analysis work“? As a discretionary technical trader with 8 years under my belt, I feel that it is my responsibility and obligation to defend technical analysis as a legitimate and effective approach to profitable trading. I use technical analysis every day, demonstrate it’s effectiveness, have the returns to prove it, and I will champion this form of analysis till the day I die. As “The Chart Addict” nothing less should be expected.

Here, we significantly diverge. Yes, technical analysis is a legitimate methodology, and yes, it can be profitable. The returns in of themselves however do not constitute a proof of a methodology, and the specific returns of Mr Lee are based on leverage. He claims 300%+, these however are leveraged returns, which negates any claims made to the methodology of technical analysis.

This article is for all of the non-believers, bashers, those holding myths about TA, those that don’t truly understand TA, and for the unfortunate ones – those that lost money and blamed it on TA. The truth is, I could really care less what you think about TA because it works for ME. Perhaps it doesn’t work for you, and that’s perfectly fine. We all trade the markets in different ways, and it’s important to use what works for you. If something simply does not “fit” with you, then you should explore other options. This goes for both TA and FA (fundamental analysis).

If it’s all about him, then any claims about technical analysis methodology in relation to others is simply spurious, and wasting everyones time.

Technical analysis, in it’s most simplest form, analyzes supply and demand through price and volume action. TA is designed to help you identify the most probable future action based on price history. Note that I did not say that TA is used for predictions the way most people would think. There are jokes that using TA is “voodoo”, “similar to using a crystal ball”, “black magic”, “hogwash”, “hocus pocus”, and whatever else you may have heard. The people that think like this truly do not understand what TA is and how it is properly used. I encourage you to open your mind and explore this realm. For those that have been following me for 1-2 years, you know that I champion TA as my most favored trading analysis.

Probability is prediction. It is a form of Determinism that utilises statistical probability. That Mr Lee does not understand this basic tenet, suggests that he does not fully understand his own craft and it’s methodology.

We are NOT trying to find out the value of a company, and in most cases, we don’t care. We don’t sit here reading 50 page reports day and night. Most technical traders have short-term horizons (day/swing) and technical analysis, in my opinion, has the upper hand for these shorter time frames. Furthermore, there are enough technical analysts that have consistently demonstrated the value of this art.

Anecdotal, and unsubstantiated anecdote, hardly constitute proof of anything. Mr Lee has a minor obsession with proof, yet, cannot actually furnish much of it.

Proven Success with Technical Analysis

Since I made my Covestor account on March 17, 2009, I still command a return north of +300%. Am I lucky? You have to be really dumb if you think that. In fact, returns for my last 4 years all exceed +100%. How is that luck?

If I started out with 1000 traders in year 1. Each year, 50% would either make 100%+ [through the use of high leverage] or blow-up, by year 4 – I would have 62.5 traders remaining. Thus statistically, it is entirely possible that it is exactly that – pure luck.

The Stocktwits community is full of tens of thousands of traders, but there are quite a few that I will personally recommend to you. Time and again, these folks have demonstrated exceptional and consistent skill from the proper use of TA: Brian Shannon, Anne-Marie, TheEquilibrium, DowntownTrader, ZMoose12, Steven Place, Kunal, ldrogen, Stewie, John Welsh, Trader Florida, Tickerville, SMB Capital, Zortrades, Misstrade, Gtotoy, and many, many others. The list is too long, but the point I’m trying to make is “how can technical analysis be rubbish if there are SO MANY successful technical traders”?

Notice the [anecdotal] universe here: tens of thousands and the winning universe – 16 [+ many, many others] Expressed as a % we have 0.00032% [using 50,000 traders] The odds don’t look so hot.

Still have something to say? Before you say anything, first prove your returns and then we’ll talk or GTFO.

Of course Mr Lee is being very disingeneous here as his returns are far from being proven. In addition we have claims of a Hedge Fund, Property Development Co. all without a shred of proof. I have watched his Charts Gone Wild, excreable, so as far as proof goes – not even close son.

So, you still don’t believe that TA works. Maybe it’s because you subscribe to only one school of thought. Or, maybe you buy an academic’s theory of efficient market hypothesis. For those that don’t know, efficient market theory states that the current price is right and past information is already reflected in the price of a stock, therefore analysis is useless.

No, just your misinformed, misleading and poor arguments to the methodology that is technical analysis. As to your critique of EMT, the shallowness of your exposition really adds little to your argument for technical analysis.

There are three sub-arguments with this theory. There is the weak, semi-strong, and the strong forms of efficiencies. The weak form states that any analysis into the history of price movement is useless. The semi-strong form states that fundamental analysis is also nearly useless. The strong form states that all information is already reflected into a stock and neither schools of analysis will help you.

The problem that you need to overcome is this: both EMT and technical analysis share a common component. This is the use of statistics and probability. You seem not to understand that the basis of your argument, essentially, is very similar to EMT.

Here’s another “argument”: “Charts are just full of stupid squiggly lines that have no meaning”. Seriously? Each price bar is important. They show you the open, close, high, and low.

What is the importance, in technical analysis, of the 4 major [historical] prices? To simply state that they are important, without demonstrating a theory, or argument, invalidates any claim to effectiveness [importance] within the methodology.

Put these bars on a chart, and you have a pictorial representation of all market participants. As a technical trader, I am more concerned about how other market participants are behaving and their reactions.

Simply incorrect. You simply have a visual record of transactions that completed at that price. You certainly do not know how many are sitting waiting to act, you do not know how many historical transactions may act again. The information you have is useful, but most certainly does not do any more than adumbrate the participants.

A good example of this is with earnings releases. A company could report stellar earnings, but the stock could gap down. Also, a stock could report a huge loss, but gap up. In some cases, a stock barely moves. The chart shows me what other traders are thinking, and that has huge value in itself.

Does it? Expound these values. Simply stating “X” does not constitute anything remotely approaching argument, theory or proofs.

How about “throwing darts on a dartboard”? This is false. Expert technicians sort through hundreds of charts to assemble only a few that are worth playing. Only charts with the best setups make the cut. How is this throwing darts? Are we lucky?

Here Mr Lee falls victim to bias. As he does not seem to understand bias, here are a few of the biases that we as traders open ourselves up to.

Sometimes, but we don’t rely on luck. We rely on concrete data presented on the charts (price, volume, MAs, support, resistance, channels, gaps, etc). Remember? Charts are created by the collective participation in the market or stock. There is significant value in analyzing the psychology behind their behaviors.

Again, Mr Lee simply drops in a word, psychology, without any further explanation, or developing it’s significance. That he also claims to be a psychology student, rather beggars belief that he can offer no insights.

There are many arguments, and if you have one to PROVE that technical analysis doesn’t work, then leave a comment and explain your thoughts. Key word is PROVE.

Well I have presented a number of arguments, although not in the comments section.

Reading the Charts

A problem with technical analysis comes in the way people interpret charts. Two people can look at a chart but have different opinions. How is this possible? We are human, we have biases, and we all have different opinions. The key is to look at a chart for what it is. I’ve seen people draw phantom trend lines that don’t exist, probably because they have a position in the stock. Manipulating a chart so that it favors you is the wrong approach to analyzing charts (and you are also lying to yourself).

Again, Mr Lee’s understanding of bias is seriously flawed. His assertion here is that his interpretation is correct, others interpretations, are incorrect.

Charts do not lie. They show what has happened already, and it’s all real. How many analysts do you know of are guilty of sticking their personal opinions in their reports? Countless. Funny thing is, many stocks with multiple firm coverage often have conflicting opinions amongst each other. What and who are you supposed to believe? The answer is to believe in only yourself. Use technical analysis as a way to make your decisions without emotions.

Mr Lee tends to jump around indiscriminately. How exactly does comparing and contrasting historical data [charts] to analysts making forward estimates [predictions] constitute proof of technical analysis as a methodology? The two are unrelated. Even if they were related, how is a negative finding in one [analysts] proof of the former [charts]

Second, technical analysis and chart analysis, which have been used interchangeably by Mr Lee are actually two different schools of analysis.

Third, emotions are vital to trading. As Mr Lee is not yet a qualified psychologist, I won’t be too picky on his ignorance with relation to the structure and function of neuroanatomy and neurophysiology.

Charts don’t move the markets, but people do. People can say anything, but what is reflected in each price bar represents what people do. People’s actions form the chart. Your trades, big or small, help create the chart. So then, does it make sense to bash charts when your trades are reflected in them?

Mr Lee seems confused, and is contradicting himself. If, charts don’t move markets, but people do – what are people basing their actions on?

We move succinctly to Random Walk Theory, which, is an offshoot of Efficient Market Theory. Of course, Random Walks are not how markets work, as markets do have memories, biases, and any number of ways in which insiders and large players can manipulate prices. As an example order flow and frontrunning, large commercial hedging etc can all distort an analysis of a chart.

If you still have doubts about TA, please tell me how you enter and exit your trades. How accurate and consistent are you? Do you sometimes have to “wait for things to work out”? Technical analysis, among the two schools of thought, has the advantage of lower-risk timing. Keep in mind that technical analysis is highly favored by short-term traders, thus accurate entries and exits are more important to us. Generally, the longer the time frame, the more important the fundamentals. It all comes down to the individual and his/her methodology and style.

How I enter and exit, again has what relevance to the arguments propounded by Mr Lee as to methodology with relation to chart analysis?

He mentions one form of risk, that of time risk. There are however many other forms of risk, one of which caught him out badly, and in his leveraged position, essentially blew-up his account.

The fundamentals, in this trade, gave the lie to his assertion that fundamentals matter more to longer time frames.

If you are a pure fundamental analyst and you are attacking technical analysis = “apples to oranges”.

I don’t even know what point he is trying to make here.

Most institutions either do not use TA or do not make it a priority. Does this mean that TA is insignificant? No! Expert technicians can follow the footsteps that are created by institutions. A good example is playing momentum breakouts on high volume – prior to the breakout.

Again, anecdotal observation. His point to methodology? None.

Many traders favor a hybrid approach of implementing both fundamental and technical analysis. I believe that this is a very powerful method of trading and it is highly recommended.

Fine, essentially I agree. But it really has no relevance to his defence of the methodology.

There is no wrong method, as long as it works for you. For me, technical analysis is my foundation and it has worked for me all these years. I would not be writing this article if I believed TA and charts were worthless.

Hardly a recommendation, nor unfortunately an exposition on why, or how the methodology has value. Essentially, I like it, so there, and blow a big raspberry.

Use what gives YOU the best advantage.

Which was surely the point initially. To highlight and describe the value of the methodology. To also elucidate the pitfalls and weaknesses, so that novices could allow for, or avoid them.

For swing trading, I personally find the weekly charts far more useful. AUY looks to be setting-up for a nice move to the upside, as are the miners generally. The reason being stable demand [see previous analysis]

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