SCHMIDT’S GOLD THOUGHTS - 7 March 2011

Kenny Rogers may not be widely known as a great philosopher, but one of his legendary songs carried a message well worth knowing. It goes, “Know when to hold them, and know when to fold them.” Last week in the game of world monetary poker, the ECB raised the limit. Now the Federal Reserve will have to demonstrate it has what it takes to play poker with the big boys. Question is not if it will fold, but when it will fold. June or sooner?

Reuters reported on the statement by ECB president Jean-Claude Trichet concerning the likelihood of the ECB raising rates at the April meeting(reuters.com,3 Mar 2011),
“I would also say that we are mentioning that we are in a posture of strong vigilance and my understanding is that the position of the governing council is that an increase in interest rates at the next meeting is possible”

Consequence of that statement has been a massive bear raid on the dollar, as market participants call the ECB’s bet and wait for Federal Reserve to reflect on its hand.

ECB, in anticipating the raising of rates, is not advocating anything particularly radical. Driving the car while looking through the front windshield has always been considered both appropriate and standard. Same is true for the “driving” of monetary policy. Central banks are charged with managing the future, not to be constantly in the process of correcting their previous mistakes.

U.S. Federal Reserve has rarely, if ever, understood that the task is the future, not the mistakes of the past. For nearly two decades, the primary mission of the Federal Reserve has been to provide low cost money to Wall Street. Beranke and his Lap Dogs, one, continue to deny that the massive financial problems of the past decade were a direct consequence of free money, and, two, continue to pursue their policy of free money for speculators.

Free money may benefit speculators, but it does little directly for those seeking to make an honest living. U.S. equity market, as measured by the S&P 500, has risen at a compound rate of about 39% over the past two years. Is that consequence of U.S. economic conditions improving at that speed? No, it, and other speculative markets, have risen because of the Federal Reserve’s policy of providing unlimited free money to speculators.

In each of the Federal Reserves speculative bubbles, some individual markets standout as the epicenters of the money binge. Internet stocks were once one. Junk mortgages were another. Today, Silver market is perhaps the center of today’s speculative binge. In the chart that follows, historical price history of $Silver is portrayed. That red arrow indicates the outline of the parabolic formation in which it has been moved.

Silver is quite clearly in a speculative bubble. Bubbles are manias that become financed with debt. As most of the trading in Silver is of the paper variety in the form of derivatives, it qualifies as a bubble. Fantasies can indeed be created and imaginary conspiracies can be concocted, but the test of reality can not be permanently denied. If it walks like a duck, quacks line a duck, and looks like a duck, then odds favor it being a duck.

Parabolic moves, such as in Silver above, are dangerous formations as they defy financial gravity. The slope of that curve increases as it rises. It is as if we threw a ball into the air, and the higher the ball goes the faster it rises, in denial of physical gravity. Reality is that in the case of both physical gravity and financial gravity, ultimately down becomes the path of least resistance.

We know several things about parabolic curves.

One, they always end. Da moon is never a reasonable price target.

Two, we never know in advance when they will end. Better to unload the truck before it is repossessed along with what it carries.

Third, the pain created when they fail is excruciating.  Breakfast is more pleasant for the chicken than the hog.

Fourth, they create great opportunities after failure. Auctions of repossessed merchandise are often good times to buy.

For more than a decade we have been doing valuation work on Gold and Silver. While certainly not perfect, that effort has served well as a guide to investing in that period. And yes, any method that also always said buy Gold and Silver would have worked well also.

Valuation, either under or over, never makes a market go up or down. It is, however, most often a precursor of the future direction of a market. And yes, we prefer the role of the chicken at breakfast. Results of that valuation are in the table that follows.

Gold is today the preferred precious metal when compared to Silver. That might not, and likely will not, prevent it from going down when the Federal Reserve folds in June. That June time period is becoming of increasing importance. The current era of free money, quantitative easing, by the Federal Reserve is scheduled to end in June. Should the ECB raise rates in April, Federal Reserve will come under increasing pressure to abandon free money policy.

Free money has been driving financial markets. Should that era of free money begin to end in June, considerable realignment of investment market values seems likely. Silver is simply the most obvious one. Deferring the investment of idle funds, and perhaps taking some profits, might be wise until the June poker hand has been played. The chicken will still be around in July.

Ned W. Schmidt
CFA,CEBS,
[email protected]