Forecasts, Commentary & Analysis on the Economy and Precious Metals
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March, 2018


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News & Views is the contemporary, web-based version of our client letter which traces its beginnings to the early 1990s as a hard-copy newsletter mailed to our clientele. The "Big Breakout of 1999" headlined in the November, 1999 issue of our newsletter moved the gold price from $250 to $325 per ounce. It was a major event.

The times have changed, but our mission has not. Simply put, it is to deliver value to our readers in the form of cutting-edge Forecasts, Commentary and Analysis on the Economy and Precious Metals. The very same mission that has been displayed in our banner for over twenty-five years.

MK Editor: Michael J. Kosares, founder of USAGOLD and author of The ABCs of Gold Investing - How to Protect and Build Your Wealth With Gold.



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The anatomy of volatility and what it means for gold
Can we use volatility to diagnose financial bubbles?
Lessons from 40 historical bubbles

"We inspect the price volatility before, during, and after financial asset bubbles in order to uncover possible commonalities and check empirically whether volatility might be used as an indicator or an early warning signal of an unsustainable price increase and the associated crash. Some researchers and finance practitioners believe that historical and/or implied volatility increase before a crash, but we do not see this as a consistent behavior. We examine forty well-known bubbles and, using creative graphical representations to capture robustly the transient dynamics of the volatility, find that the dynamics of the volatility would not have been a useful predictor of the subsequent crashes. In approximately two-third of the studied bubbles, the crash follows a period of lower volatility, reminiscent of the idiom of a 'lull before the storm'. This paradoxical behavior, from the lenses of traditional asset pricing models, further questions the general relationship between risk and return." – Didier Sornette, Peter Cauwels and Georgi Smilyan, Swiss Finance Institute / ETH Zurich

Click to enlarge

Why are the ETH Zurich findings important now – after we have already had the first wave of a potentially larger stock market crash that could occur at some point down the road?

First, Sornette and company have it right, at least insofar as volatility and the current stock market bubble goes. The low volatility from January, 2016 to present, as shown in the chart above, was the "lull before the storm." So their theories deserve serious attention.

Second, what we have experienced thus far, as ETH Zurich goes on to point out in its lengthy study, might be only the first phase of what could develop into a full blown crash with severe implications to the economy as a whole. It uses the 1929 crash (and 39 other episodes) as an example:

"Then [after the initial crash], volatility shoots up massively, but this is clearly the direct consequence of the crash and cannot in any way be used as a precursory warning signal of the bubble. One can also notice that, after its explosive growth in October 1929, the volatility decreased in the four months following the crash, but started to increase again afterwards. This is a signature of the fact that the crash was only the beginning of what would develop into a multi-year depression that impacted severely the stock market, which would find an absolute low of 41 on July 8, 1932, corresponding to a total cumulative drop of 89% since the all-time peak on September 3, 1929."

An interesting chart accompanies that statement (not included here but worth a close look at the link below). I include this passage not so much to suggest an outcome, i.e., deflation, disinflation, inflation, stagflation, et al, but to alert our readers that the first signs of volatility may be, in fact probably will not be, the last. In their study, they show a massive spike in volatility almost four months after the initial surge in October, 1929.

Third, and most importantly from the perspective of current and would be gold owners, it is important to understand that in recent history volatility has preceded upward movement in the gold price, as shown in the volatility index chart (VIX) above. Volatility, as ETH Zurich points out in the first quote above, may not spike before the crash, but it most certainly has surged in the past before an increase in the price of gold.

Gold has been under cross examination over the past month as to why it hasn't gone up while stocks have gone down. Just as complacency and low volatility were the "lull before the storm" in the stock and bond markets, the hesitation to buy gold might be a reaction among investors akin to the deer being caught in the headlights. The true reaction – bolting for the woods – might be yet to come, as gold's performance relative to the VIX in the chart above indicates.

Please see: Can We Use Volatility to Diagnose Financial Bubbles? Lessons from 40 Historical Bubbles / Swiss Finance Institute Research Paper No. 17-27 / Sornette, Cauwels, Smilyanov / July, 2017

Gold Chartography 101

Gold One year – This chart offers some much needed perspective. Gold was down 3% for the month of February, not its best performance, but not disastrous in the overall scheme of things. Stepping back and taking a broader look, we see that the metal has appreciated steadily over the past year – up almost 5% – in an interest rate environment where yields on a 10-year Treasury bill are running between 2.5% and 3%, and the greatest concern among market watchers is the potential return of inflation. We also see that the one-year chart remains in a pattern of rising lows and rising highs – a quiet trend that bodes well for the future, and speaks to gold's underlying strength.

Yields on various U.S. Treasuries (note spike in short term rates) – In late February $258 billion in U.S. sovereign debt paper went out the Treasury's door – the second largest amount over a three day period in history, and $1 billion short of the record set in 2010. "Wall Street and investors," reported Reuters' Richard Leong, "took down with relative ease this week's flood of government bond supply that included record amounts of three-month and six-month T-bills. But that came at a cost. The Treasury Department paid the highest interest rates in more than nine years to dealers and investors to buy its short-term debt." It is interesting to note that in the wake of those sales, gold immediately began to firm up. In the past, rising interest rates have been a thorn in gold's side. In the new economic regime with annual $1 trillion + deficits on the horizon, they may become the burr under its saddle.

Goldman Sachs Commodity Index (GSCI)– Bloomberg quotes JP Morgan on the prospects for commodities: "Inflation's back and raw materials stand to benefit. . .which has raised price forecasts for metals. 'Inflation has come and it should be good for commodities,' the bank said. . .Among signs of the shift, JPMorgan cited stronger U.S. wage numbers as well as recent core consumer price inflation." With that, JP Morgan jumps on the commodities bandwagon. As go commodities, so goes gold.

Source: TradingEconomics.com

Gold price annual average 1970-2017 – Though gold's fluctuations day to day are the center of much attention, for long-term investors the chart on average annual prices tells a more placid and comforting tale – one that speaks convincingly to the twin notions of averaging your purchases over time and buying the dips.

Inflation-adjusted gold price: With inflation concerns and expectations on the rise, I thought posting the gold-inflation adjusted chart a worthy enterprise. Its most helpful feature is that it shows us where the price of gold would have to go in order to match performance levels of the past once currency depreciation is taken into account. Most gold holders are interested in what the inflation-adjusted price of gold would need to be to match the 1979-1980 nominal high just under $900 per ounce. The answer, as you can see, is about $2200 per ounce. We should keep two things in mind when contemplating that number. First, gold anticipates inflation, as it did in the 1970s run-up, so the $2200 number is by no means a ceiling. Second, this chart is based on the Consumer Price Index measure of inflation which many analysts believe to be flawed and understated.

Source: MacroTrends.net

Investor note: As is the case with any chart analysis, we want to emphasize that the commentary with the charts posted above is opinion should be evaluated as such by the reader. For more information, we direct you to the caveat at the bottom of the page and our full risk disclosure posted here.

Notable & Quotable

Words of wisdom on market bubbles, Old Maid, hubris and market crazes

"I would say we are in a bond market bubble and a bond market bubble really means is that prices are too high and when they move down long term interest rates move up. And if you take a look at the structure of not 'price-earnings ratios' but 'earnings-price ratios' in the stock market, you find that the critical issue of what engendered some of the strength in recent periods is essentially the decline in real long-term interest rates as it factored into the market. That is in the process of changing and I think that the bond market bubble is now beginning to unwind and that is going to bring us ultimately into a state of stagflation and beyond that it is very difficult to tell. This is not an easy economic outlook because there are too many variables which we haven't seen in recent decades." – Alan Greenspan, former Fed chairman

"To suppose that the value of a common stock is determined purely by a corporation's earnings discounted by the relevant interest rates and adjusted for the marginal tax rate is to forget that people have burned witches, gone to war on a whim, risen to the defense of Joseph Stalin and believed Orson Welles when he told them over the radio that the Martians had landed." – James Grant, Interest Rate Observer

"For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a pastime in which he is victor who says Snap neither too soon nor too late, who passed the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated." – John Maynard Keynes

"At the quarter-century mark of 1925, the great bull market was under way, and Graham*, then 31, developed what he later described as a 'bad case of hubris.' During an early-1929 conversation with business associate Bernard Baruch (about whom he disparagingly observed, 'He had the vanity that attenuates the greatness of some men'), both agreed that the market had advanced to 'inordinate heights, that the speculators had gone crazy, that respected investment bankers were indulging in inexcusable high jinks, and that the whole thing would have to end up one day in a major crash.' Several years later he lamented, 'What seems really strange now is that I could make a prediction of that kind in all seriousness, yet not have the sense to realize the dangers to which I continued to subject the Account's4 capital.' In mid1929, the equity in the 'Account' was a proud $2,500,000; by the end of 1932, it had shrunk to a mere $375,000." – Frank K. Martin, A Decade of Delusions

* Benjamin Grahm, "The father of value investing", 1894-1976, Security Analysis (1934) with David Dodd, and The Intelligent Investor (1949).

"Ex-chairman of the Securities and Exchange Commission Harvey Pitt had a withering take on the current state of the stock market, which has seen average speculators crushed by short-volatility products and speculators gripped by a fervor around blockchain-related assets. Pitt told CNBC during a Friday morning interview that the U.S. has 'become a nation of day traders.' The Brooklyn-born, 72-year old legal professional was the 26th SEC head from 2001-2003 during George W. Bush's first term. . . "The problem we have," Pitt goes on to say, "is that most people investing in these companies are doing it because they want to partake of a craze and they don't have any idea why they're making their investments or what the companies do." – Mark Decambre, MarketWatch

Editor's note: As many of you already know, Alan Greenspan is a staunch advocate of personal gold ownership as a means to hedging his outlook – a return to the stagflationary 1970s. John Maynard Keynes aptly describes the nature of the stock market game particularly at the top of the cycle. One does not want to end up with the Old Maid. James Grant in his inimitable way sums up the psychological framework of a stock market bubble. He too is a staunch advocate of gold ownership for private investors. Bernard Baruch became a gold owner during and after the crash of 1929 once telling the Secretary of the Treasury that he was "commencing to have doubts about the currency." Harvey Pitt's observations are worth taking to heart particularly when you consider the chaos likely to ensue when all the day traders attempt to squeeze out the door at the same time.

Why diversifying beyond mainstream asset classes makes sense

"I want to own commodities, hard assets, and cash. When would I want to buy stocks? When the deficit is 2%, not 5%, and when real short-term rates are 100bp, not negative. With rates so low, you can't trust asset prices today. And if you can't tell by now, I would steer very clear of bonds. Just think, Greece will have a budget deficit below 2% of GDP by the time ours grows to 5%-plus. The markets disciplined Greece for its budget transgressions; it's just a matter of time before they discipline us. I think that time could be starting now with 10-year Treasuries rising to 3.75%, and 30-years to 4.5%, by year-end, and those are conservative targets." – Paul Tudor Jones, Tudor Investment Corporation

"Well, these things usually move in a hyperbolic curve. They start out slowly. Then, they accelerate. Same type of thing we saw with cryptocurrencies. I think gold will do the same, although not to the same extent. My prediction by the end of this year is that gold will hit $2,000. In 2019, $3,000. In 2020, $4,000. By the time this bull market peaks, gold could reach $10,000. But I hate to say things like that…because it sounds so outrageous. But look at the number of dollars in existence ($3.635 trillion in the M-1 money). Divide that by the 260 million ounces of gold the U.S. Government is supposed to own, and you get a gold price of $13,982/ounce." – Doug Casey

"Any inflation erodes the purchasing power of portfolios. Rising inflation has historically been a drag on inflation-adjusted stock and bond returns, making diversification beyond mainstream asset classes more important. Conservatively positioned, income-oriented retirees tend to be more exposed to inflation risk than more aggressively positioned young workers. A strategic allocation to a mix of inflation-resistant assets including commodities, gold, commodity-linked stocks, and short short-duration bonds — may help investors manage these risks." – Fidelity Investments

"While the main goal of investing is to grow one's wealth, cautious investors should consider how to preserve their wealth in the event of a sudden market crisis. . . One way to invest in the asset is to buy bars and coins made from a precious metal. This avoids counterparty risk: if you owned gold through a brokerage, there is a risk the broker could go insolvent." – Luke Grahm, City AM

"Heading into 2018, silver was one of the top picks in the commodities complex among traders and money managers. Moreover, unlike gold, silver sees much higher industrial demand. The precious metal enjoys heavy industrial demand that benefits from an expanding global economy. ETF Securities "reiterated its forecast for the precious metal to trade in a range between $19 and 20 an ounce by the end of the year."

"Perhaps we slow investors should adopt a mascot. I suggest the sloth. Hanging upside-down, moving at a few metres a minute, is much like trading infrequently: it saves the costs of doing things more quickly. Sloths take almost two months fully to digest each meal — which is handy, given that they eat mildly toxic leaves that would poison them if absorbed too quickly. Investors are reminded, all too often, that the financial world is lush with toxic get-rich quick products. A slower approach to finance makes market movements a great deal more digestible." – Tim Hartford, Financial Times/The Undercover Economist

"The best thing is, don't play the game, because it is pros against you. We spend hundreds of millions of dollars a year to get an edge, and others do that too. So it's very difficult for the individual investor to assume that he [or she] can pick something better. The best thing you can do is know how to have a balanced portfolio … because you ain't going to win that game." – Ray Dalio, Bridgewater Associates, speaking at the Harvard Kennedy School's Institute of Politics

Editor's note: Ray Dalio states flatly what many of us think from time to time: No matter how qualified we think we are, we cannot match the apparatus at the disposal of the market's top traders. Gold fits Dalio's balanced portfolio approach so much so that Bridgewater Associates, the hedge fund he manages, owns significant amounts of gold despite the fact that he has an arsenal of knowledge, experts and software at his disposal. The lesson to be learned is that, if you know anything about the nature of contemporary fiat currencies and financial markets, you will have gone to the trouble of diversifying before, not after, the inevitable day of reckoning arrives.

Along these lines, I have to admit that a sloth-like approach to portfolio design fits my worldview. I have never been much of a trader and I do find that if I buy an investment for the long-term and essentially forget about it, I do much better than the opposite. That's why I am content with physical gold ownership. My attitude is to buy it, stick it in the safety deposit box and forget about it. The investors I know who take a similar attitude seem to be the happiest, and ultimately, the most successful gold owners. I guess if you believe in it – believe in what it can do for you – you do not need to check on it constantly, fret about it and seek constant validation that you did the right thing by diversifying your holdings. When it comes to investment there are bulls and bears and then, as Tim Hartford points, there are the sloths. Count me among the sloths. . . . .

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Disclaimer - Opinions expressed on the USAGOLD.com website do not constitute an offer to buy or sell, or the solicitation of an offer to buy or sell any precious metals product, nor should they be viewed in any way as investment advice or advice to buy, sell or hold. USAGOLD, Inc. recommends the purchase of physical precious metals for asset-preservation purposes, not speculation. Utilization of these opinions for speculative purposes is neither suggested nor advised. Commentary is strictly for educational purposes, and as such USAGOLD does not warrant or guarantee the the accuracy, timeliness or completeness of the information found here. (Please see our Risk Disclosure here.)

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