Stock Trading: Thoughts On Inflation And Gold

With today’s (Wednesday) mild rally, followed by a weak close, the market demonstrated indecision more than anything. Looking at the SPY (SPY) one day chart, we can see the range bound action late in the day, and the end of day selloff. I kept expecting the market to take off, but every move toward the highs was met with sellers.

The sense I get is that too many participants are in a forced sell mode due to margin calls or other manifestation of investment strategies that are now failing. It is impossible to know how long this process will take. It is difficult to find a trading edge in such an environment.

There has been considerable speculation as to whether the crisis and government reaction will be inflationary or deflationary. Certainly when it comes to the dollar and most commodities, market action has so far indicated the latter. Steve Saville asserts that the initial deflationary trends will give way to inflation with respect to certain asset classes, particularly gold.

By way of further explanation, during the early part of a major upward trend in money-supply growth it will typically be the case that inflation is not widely perceived as a problem. Actually, it’s quite likely that deflation will be seen as the bigger threat. This is the situation that we often refer to as a “deflation scare” — rising money-supply growth (inflation) combined with rising fear of deflation, with the fear of deflation being fanned by falling commodity and equity prices.

During the early part of an inflation cycle the demand for cash balances will tend to be relatively high — due to falling inflation expectations — and the average economist will perceive a low “velocity of money”. But as time goes by the effects of the increased rate of money-supply growth will start becoming apparent and people will become a little more conscious of the inflation threat, the result being a decline in the demand for cash balances (people will begin to save less cash). The average economist will interpret this as an increase in the velocity of money and may well conclude that prices have begun to rise in response to the increased velocity. Clearly, though, both the increase in velocity and the rise in the general price level are just lagged EFFECTS of the preceding money-supply growth.

…We understand that a provision allowing the Fed to pay interest on bank reserves was included in the Troubled Asset Relief Programme (TARP) approved by Congress late last week. This means that the Fed can now inject unlimited amounts of new money into the financial system without having to worry about pushing the Fed Funds Rate below its target.

…Value is always a matter of opinion and there are many smart people in the world who disagree with our assessment of relative value, but from our vantage point the broad stock market’s high P/E ratio and low dividend yield disqualify it as a likely big winner from the coming inflation. The bond market also looks over-valued, as does the property market. Commodities are likely winners because in most cases their prices remain low in real terms and because the large nominal price gains of the past several years have not yet brought about large increases in supply, but industrial commodities such as oil and the base metals could languish for quite a while in response to the global growth slowdown. Gold, however, often benefits from illiquid financial markets and economic weakness due to its historical role as money. Furthermore, we think gold is cheap relative to most other commodities and most other investments.

Saville notes that it might be 1-2 years before increased money supply has an effect on commodities in general, but also says that gold occupies a unique role. Due to speculation, we could see price run up much sooner.

Looking at the GLD (GLD) chart, we can see that price rose today above the 200 day moving average with increasing volume. Going back to March, however, we have lower highs and lower lows in place. This chart will start to look much more bullish if the price rises above the 97.50 area. At the same time, given economic fundamentals and the rising demand for physical gold, this appears to be a prudent place to be gradually building a position.

Some miners are showing signs of a bottom here. These are similar patterns with big, high volume surges off the lows. In a best-case scenario, they pull back on low volume to offer an attractive entry.

Freeport-McMoRan Copper & Gold (FCX):

Yamana Gold (AUY):

Newmont Mining (NEM):

Cleveland Cliffs (CLF):

Another chart that interests me is RSX (RSX), the Russia ETF. The Russian market has lost over 2/3 of its value since May. Looking the chart, we may have had a selling climax, followed by buyers coming in today with increasing volume. I am holding a small position, and will be looking for opportunities to add.

As we look to the future, it is worth considering how various countries are situated to deal with the crisis. Wikipedia has a page detailing countries by current account balance. The countries with the largest current account surpluses are, in order, China, Japan, Germany, Russia, Saudi Arabia, and Switzerland. Those with the biggest deficits are, in order, USA, Spain, United Kingdom, Italy, and Australia.

I am not an economist, so I am just starting to work through the ramifications of numbers like these. Comments are welcome.

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