Many gold bugs make an implicit assumption. Gold is good, therefore it will go up. This is tempting but wrong (ignoring that gold does not go anywhere, it’s the dollar that goes down). One error is in thinking that now you have discovered a truth, everyone else will see it quickly. And there is a subtler error. The error is to think good things must go up. Sometimes they do, but why?
First, we think it’s a cop-out to say, “well it’s all subjective.” If it were all subjective, then there would be no way to say that gold is good, and no way to say that it “should” go up. It would be sufficient to say, “gold is $1,276.” Indeed that is all that one could say, if everything were subjective.
Why is gold trading at that price? Subjective preference, nothing more. Will it trade at $12,760? Maybe. If subjective preference changes. One might as well say “if God wills it.”
But it is not all subjective. There is something objectively wrong with the dollar and all of its derivatives such as euro, pound, yuan, etc. They are all slowly failing. Gold is the alternative to holding the dollar.
It is important to keep in mind that most people do not like to buy on speculation. This may be particularly difficult to understand if you are someone who bought gold as a bet on its price. Most people buy, not because they expect a discontinuous change, but simply because they have goals to achieve.
For example, a consumer buys food because he needs to eat. A business buys copper because it manufactures wire, or circuit boards, or chemicals to pressure-treat wood. That’s what businesses do—buy inputs, combine them into a product, and sell it for a profit.
Will copper go from $3.02 to $4.02? Maybe. But that is not why copper-using businesses buy it (at least not in the falling interest cycle—see part IV of Keith’s Theory of Interest and Prices).
Suppose Acme Piping Inc. buys copper at $3.02. It adds $1.98 worth of labor, and turns the metal into pipes. It sells a pound of pipes for $6.00. It spends $5.00 ($3.02 + $1.98). We can say that this $1 of profit is an incentive to produce plumbing.
And there is another incentive. If Acme has a debt of $1,000,000, with a monthly payment of $15,000, then it must sell at least 15,000 pounds of pipes. If not, then its creditors will seize the business. It would like to sell at least 20,000, so it makes the payment, and has a profit of $5,000 left over.
If you wonder why the “worthless paper dollar” can buy so many great products, it’s because every debtor is exchanging whatever it can produce and sell to get enough dollars to service their debts.
When the interest rate falls, several things change. First, the incentive to borrow increases. If Acme had decided not to borrow to buy a new pipe-making machine when the rate was 6%, the company may be more tempted at 3%. Total debt goes up as more businesses take this greater incentive.
The monthly payment per dollar of debt is lower (total debt may be a lot higher). However, it becomes harder to generate the profits to service the debt. When every pipe manufacturer borrows more to add more machines to make more pipes, the price of pipe tends to fall. Taxes and regulations might slow or prevent the drop in price, but not the drop in profit margins.
So let’s look at a chart of the price of the S&P stocks overlaid with nonfinancial corporate debt (not the same as S&P 500 debt, but we use it as a proxy for data we don’t have). We started the graph in January 2008, so you can see the big plunge from 1400 in May 2008 to 734 in February 2009.
Source: Nonfinancial Corporate Debt, St. Louis Fed
Acme Piping, Acme Banking, Acme Pharma, and 497 other Acmes are steadily adding to their debt. According to this data series, borrowing did not miss a beat, even in the worst of the financial crisis. This debt is quoted in millions, so total nonfinancial corporate debt nearly doubled from $3.4 trillion to over $6 trillion.
Aside from buying more machines, companies use some of this borrowing to buy back their shares. There is a reasonable argument for this, as debt and equity are alternative ways to finance the enterprise. And the lower the interest rate, the more attractive debt becomes.
Many companies are also paying dividends. Management has a tougher case, to argue that borrowing is used for other purposes, and dividends are paid of out of cash flow. However, cash is fungible. If a company is adding debt at the same time, it raises the question if it is borrowing to pay the dividend. The fact is that cash comes in from borrowing, and goes out for dividends.
Stocks have been rising relentlessly since 2009. We don’t know how much of the rise is due to borrowing for so called “shareholder friendly” actions. The graph certainly shows a strong correlation. We can say that these moves may seem “friendly”, but actually create a problem for long-term shareholders. Debt is rising. As the expression goes, “it’s not a problem until it’s a problem.”
Until it’s a problem, speculators keep buying stocks to front-run relentless “shareholder friendly” actions by the public companies.
Most have been trained not to think about yield, but to think about capital gains. Preferably big capital gains. They don’t see the engine of capital destruction, as each buyer in turn, turns over his capital to the previous owner of the asset. The buyer would never consume his own wealth, or want to be the Prodigal Son. However, to the previous owner who is now selling, it comes as income. Which he happily spends. This is a process that must inevitably end, when it depletes all capital that people are willing to put into it.
Speaking of yield, here is a graph showing the S&P index again, this time with earnings and dividend yield.
Source: Earnings and Dividend Yield, multpl.com
Earnings yield is the stated earnings of the companies in the index divided by price. Dividend yield is the dividend over price. Yield is an interesting view, because it lets us compare earnings or dividends to other assets, such as the Treasury bond.
The problem with earnings is that it can be difficult to determine what went into it. Companies can actively “manage” the earnings number. For example, deferring maintenance or reducing R&D will boost earnings. At least for now. Public companies use the accrual basis for their accounting. With accrual accounting, it’s quite possible to have negative cash flow while reporting positive earnings.
Dividends are thought to be harder to dress up. This is because they are paid of out of cash flow, or so the theory used to hold. However, as noted above they are increasing their borrowing.
Both earnings and dividend yield are falling. In contrast to the 10-year Treasury bond at 2.4%, the earnings yield of the S&P stocks is under 4%. The dividend yield is under 1.9%. This shows that people prefer stocks strongly over the steady yield of the bond. This is extraordinary, given that stocks carry substantial risk of capital loss. Heck, our chart above shows a loss of about 50%. We think that stock buyers want that risk. They don’t see much downside, only upside.
This common belief does not mesh with another common belief that interest rates will rise (which we don’t share). With rising rates, of course bondholders will take capital losses. But holders of equities will take bigger losses.
But until then, until it’s a problem, most people buy stocks. The prospect of buying gold as a way to opt out seems unattractive to them (perhaps they will be more excited by a gold fixed income investment).
The price gold dropped $10, but the price of silver increased 18 cents.
Is this the end of the downtrend that began around 8 September? Last week, we said:
One way to think of these moves is as the addition of energy into the market. Like tossing a pebble into a still pond (not quantity of water, but energy that perturbs it). Once the speculators get the idea that gold and especially silver should go up, well it becomes self-fulfilling. Statements by the Fed, the ECB, or even the fatboy who rules North Korea can all have an effect.
This week the action occurred on Friday, after the employment report by the Bureau of Labor Statistics. They said unemployment fell by 0.2%. They may as well have said “Buy silver because, inflation!” or maybe “buy silver, because growth!”
In any case, people sold silver first, down to $16.30 shortly after 10am NY time. Then they did buy silver, pushing it up to $16.85 an hour and a half later.
We continued:
Buying begets buying, as the chart shows signs of a breakout. But then, especially in this moribund market, the energy of new speculation is depleted. And the price subsides, until new energy is added by the next event. We are in that mode right now.
Is this another case of new energy fueling speculation while the market remains moribund?
We will look at an updated picture of the fundamentals of supply and demand of both metals. But first, here are the charts of the prices of gold and silver, and the gold-silver ratio.
Next, this is a graph of the gold price measured in silver, otherwise known as the gold to silver ratio. The ratio fell.
In this graph, we show both bid and offer prices for the gold-silver ratio. If you were to sell gold on the bid and buy silver at the ask, that is the lower bid price. Conversely, if you sold silver on the bid and bought gold at the offer, that is the higher offer price.
For each metal, we will look at a graph of the basis and cobasis overlaid with the price of the dollar in terms of the respective metal. It will make it easier to provide brief commentary. The dollar will be represented in green, the basis in blue and cobasis in red.
Here is the gold graph.
No surprise here. As the price of the dollar has risen (most people see the inverse, the price of gold measured in dollars, which has fallen) the scarcity of gold has risen too.
However, scarcity has not risen so much. On 7 Sep, the price of gold hit $1,347. The cobasis was -1.2%. On Friday, the price of gold was down $75. The cobasis was up to -0.82%.
During that time, our calculated Monetary Metals gold fundamental price is down from $1,371 to $1,333.
Now let’s look at silver.
It is the same picture in silver. The price has fallen from over $18. The cobasis has increased, but not that much. Keep in mind in silver, the near contract tends to move more towards backwardation sooner than gold. We are now within the zone for this.
Our calculated Monetary Metals silver fundamental price is down from $17.83 to $16.98.
Friday’s action was, to say the least, interesting. First the prices dropped sharply then rallied to a higher level. In Part II of this article, we have graphs of the Oct 6 Gold and Silver Intraday Basis and Cobasis.
© 2017 Monetary Metals
The overall analysis here is excellent as always, thanks for writing it.
Still, I am puzzled by the use of the terms “objective” and “subjective”, in the intro which seem to be used precisely backwards here.
It was surprising to see that in a write up which is otherwise so carefully and thoroughly reasoned.
For instance, the dollar going down can’t be “objectively” good or bad in a vacuum. It is objectively good for some and objectively bad for others, depending on their subjective preferences.
Of course, there are many things we can “objectively” say about the dollar–such as its current price in fractions of gold grams, or that it is considered legal tender in the US, or the rate at which new ones are being created.
But it can only be “objectively bad” at fulfilling some subjective preference–such as having a stable and predictable currency. (A very reasonable subjective preference to hold!)
However, if one owes a lot of money and would like to pay it back in cheaper dollars, then the dollar going down is objectively *good* at fulfilling that subjective preference.
Therefore, unless you are adding other qualifiers, whether the dollar going up or down is “good” is entirely subjective. It is good for some and bad for others.
It is only in reference to a specific standard or goal, that it can be “objectively” good or bad. Without referring to some other standard, those words become subjective qualifiers.
The same is true of gold: It is not objectively “good” in and of itself. It can be objectively good at helping to meet certain subjective values, or it can be *subjectively* considered a good thing to have in and of itself by a certain person.
I think I may understand the confusion here: Just because a position is well-reasoned does not make it “objective”.
It can still be subjective in that it appeals on some level to personal values and preferences rather than empirically verifiable claims.
The error is most clear in this piece when it is argued that if we were speaking subjectively, “all” we could say is that the market price of gold is currently $xxxx. But that’s exactly backwards: This is an objective empirical statement, not a subjective statement of value or preference.
Fortunately, the underlying point of the piece and of the exercise is clear enough to withstand these unconventional uses. But it could lead to issues in other discussions and in thinking reasonably on other related topics.
Pardon the long reply, and I hope it’s not overly pedantic or nitpicky. It’s just such a foundational set of terms, and I’d like to flag this for your future consideration, as it may stop many otherwise receptive readers in their tracks.
Thanks for hearing the critique, and please keep up the great work. It really is an excellent read aside from this issue, which nearly stoped me from finishing. So I may not be alone. Fortunately, I’m familiar with the great quality of your work and knew to stay for all the good stuff! :) So thank you for that.