Tuesday, January 15, 2008

Mike Shedlock's Confused Analysis of Gold

Because he keeps repeating this nonsense, I feel I must response to Mike Shedlock's absurd analysis of gold. Mike Shedlock is generally wrong about inflation, and since the facts so obviously contradict him, he keeps repeating nonsensical arguments to explain his disconnect with reality. I don't have the will, time or energy to correct him each time he presents nonsensical argument, but since he seems to repeat the argument about gold so often and because gold is so important, I will make an exception here.

The most obvious indicator of the rampant inflation we're facing is the surge in the price of gold. Gold is not a cyclical commodity, so it isn't affected by concerns over the effects of the U.S. recession, like oil and industrial metals are. Nor can it be manipulated like the government price indexes, so its rise provides good evidence of inflation-and an increasing willingness to hedge against inflation.

The sharp increase in the price of gold thus provide conclusive evidence against the belief of Mike Shedlock and many others that we're experiencing deflation.

However. Mike Shedlock have absurdly tried to re-interprete this into a support of his deflation prediction. Here for example he tries to claim that higher gold prices is consistent with deflation in paper money by claiming that it signals "a destruction in fiat credit and a rise in the value of real money". The part about destruction of fiat credit is completely out of touch with reality as bank credit is in fact soaring and his talk about a rising value of real money is only true if you define gold as real money. But in that case his assertion is a mere tautology which says that higher value of gold is associated with higher value of gold. This tautology is of course completely irrelevant for the issue of how rising value of paper money affects the price of gold.

And there are two good reasons for believing that a hypothetical price deflation in paper dollars would lower the value of gold. First, it is the direct effect from higher value of paper dollars, which will lower the price of gold in paper dollars. Secondly,and arguably even more importantly, if there is no inflation in paper dollars it makes no sense at all to own gold, except for maybe jewelry purposes. Gold pays no interest or any other form of nominal return, so if there is no inflation, any bonds or stocks with positive nominal return is a better investment object. And so, if price deflation in paper dollars would be reality, the investment demand for gold would collapse, causing prices to collapse too, just like the great disinflation of the early 1980s caused the price of gold to collapse.

Thus ironically, the only way for Shedlock's gold forecast will be correct is if his macroeconomic analysis of inflation/deflation is incorrect. Similarly, if his macroeconomic analysis of inflation/deflation would be proven correct, his gold forecast would become dead wrong.

So, because his analysis is so absurd, the only thing we can be absolutely sure of is that he will be wrong about some important forecast.

7 Comments:

Anonymous Johan Nilsson said...

Stefan, here's a six year old's question: If the gold price is a result of inflation expectations, how come that stocks are not rallying? After all, inflation means that you should own real things, not cash, and a share of a company is definitely something that cannot be inflated away.

Even if I'm only six, I have some thoughts about why there is a flight from stocks to bonds and gold, but I'd be interested to hear your view first.

12:10 AM  
Blogger stefankarlsson said...

Johan Nilsson, That is very easy to explain. The reason why stocks aren't rallying is because the underlying fundamentals in the form of corporate profits is deteriorating.

Relative to underlying fundamentals, stocks remain as overvalued as ever.

12:17 AM  
Anonymous Johan Nilsson said...

The six year old's response: Shouldn't corporate profits be expected to rise in an inflationary environment?

I'd be interested to hear your view on that, and on these thoughts as well:
1. Deflationists don't own gold, so there is no sell-off in that market. Inflationists can't buy stocks since the deflationists sell.
2. Different inflation hedges can be over- and undervalued. Gold could be undervalued right now and stocks overvalued.
3. Gold price is driven mainly by other demands than inflation hedgeing. For instance, in Asia the metal has an almost religious meaning. I have heard that a dowry in India has to be payed in gold.
4. The gold market is to some extent irrational and since the market is a tiny one compared to the stock market that irrationality can have effects. With enough people saying "They talk about deflation. That sounds horrible, I'd better buy gold" the gold price could be affected.
5. Stocks are used more than gold as a security for loans. This means that stocks are a part of the monetary system. Stocks are used to create new money, gold not. And probably stocks are to greater extent bought with borrowed money. The leverage is therefore higher, and so the risk. Sooner or later the risk becomes too high (people can't pay the interest rate with their wages) and the sell-off has to start.

10:55 AM  
Blogger stefankarlsson said...

"The six year old's response: Shouldn't corporate profits be expected to rise in an inflationary environment?"

No, not in the case of stagflation. Remember, I'm not simply arguing for the existence of inflation, but also of a recession. In other words, I am arguing for stagflation. And the "stag" part of stagflation is pushing down corporate profits.

"Deflationists don't own gold, so there is no sell-off in that market. Inflationists can't buy stocks since the deflationists sell."

So? What relevance does this have?
If inflationists started to change their mind, then they would sell gold.

"Different inflation hedges can be over- and undervalued. Gold could be undervalued right now and stocks overvalued."

Well, yes.....

"Gold price is driven mainly by other demands than inflation hedgeing. For instance, in Asia the metal has an almost religious meaning. I have heard that a dowry in India has to be payed in gold."

Sure other factors affect the gold price. But I don't think it is as important factor as inflation hedging.

"The gold market is to some extent irrational and since the market is a tiny one compared to the stock market that irrationality can have effects. With enough people saying "They talk about deflation. That sounds horrible, I'd better buy gold" the gold price could be affected."

Yes, market participants are often irrational. But I don't think they'll be irrational enough to buy
gold during deflation in paper dollars.

"5. Stocks are used more than gold as a security for loans. This means that stocks are a part of the monetary system. Stocks are used to create new money, gold not. And probably stocks are to greater extent bought with borrowed money. The leverage is therefore higher, and so the risk. Sooner or later the risk becomes too high (people can't pay the interest rate with their wages) and the sell-off has to start."

Well, I guess that is a possible scenario.

11:54 AM  
Anonymous Johan Nilsson said...

OK, thanks for the response to my thoughts. I hope you interpreted them as constructive. They are by no means definite.

Regarding stagflation, yes, real economy will slow down and companies will sell fewer goods and services. But nevertheless nominal profits should be able to rise or stay level with more money available. A company is from an investment point nothing more than a cash flow that you want to take part of. Stocks should be more attractive than bonds in a stagflation scenario, since the cash flow can rise with inflation. To sell stocks and buy bonds makes sense only if you expect deflation.

The relevance with thought 1 was the fact that stock and bond prices are falling, while the gold price is rising. There could be two "camps" targeting different markets. Just a loose thought.

1:06 PM  
Blogger David said...

Mish's view that gold does well in deflation hasn't been fully tested yet. However, Mish not only predicted the financial collapse, but he also forecast the rise in the dollar last year and the fall in commodities other than gold which hit a lot of 'inflationists' pretty hard. And if we have not experienced deflation yet, we have certainly experienced its effect on prices - house prices are down, cars are down, oil is down, airline fares are down and I would bet these things continue for the next few years.

5:35 AM  
Blogger stefankarlsson said...

David, yes, but he didn't predict the commodity price rally that preced last year's brief slump-or the rally we've seen this year.

8:10 AM  

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