Reprinted from Seeking Alpha

September 18, 2014
 

Here is an extended excerpt from that article that I think is worth looking at from where we are now:

 

"Everything Is Just Fine...Except"

July 15, 2014

 

A geologist had this theory all of his life. He talked to his colleagues about it, taught his students about it, and in his later years took a trip half way around the world to prove it. He went to the mountain where the specific rocks existed that would prove his theory. The placement and the kind of rocks were crucial to his thesis. He climbed to the top of the mountain and inspected the rock formations and how they laid on the side of the mountain. Everything was exactly as he figured -- except for one rock that wasn't supposed to be there, and which contradicted all of his conclusions. He pondered the situation, and then pushed the rock off the mountain.

 

Moral of the story: if you're a truth seeker, you accept the rock and you change your theory.

 

From the beginning of the year I've expected gold to go up due to higher demand led by higher world growth and higher inflation. Problem: there's this rock in front of me that doesn't belong there. All was going well until about ten days ago. Suddenly agricultural commodities, oil, and the CRB have all fallen -- "like a rock" so to speak. This means that gas and food prices will fall, and soon. As of today, inflation may have just peaked. It happened very abruptly.

 

There are counter signs, like copper and precious metals that are still moving higher signaling higher inflation and world growth. Yet bonds continue to move lower which contradict this trend. I assumed world growth would increase this year, but as of this week's foreign data, most countries are suddenly falling backward, not moving forward.

 

France fell to zero growth in the first quarter and to date is running a negative growth rate. Germany and Japan are turning down and looking surprisingly weak lately. China is struggling. And Canada's unemployment just ticked up to the highest since last summer. Then there's the PIGS: Portugal, Italy, Greece, and Spain which are back in the news as a new Euro crisis has suddenly reappeared. I could go on, but the bottom line is the world-wide recovery is now in question.

 

The US appears to be doing well plodding along with a three handle on GDP. And inflation concerns have risen, replacing deflation concerns, which under the circumstances is good. But the M2 money supply from the first of the year to the present has only moved from (in trillions) $11,131 to $11,233. In the last six months it's virtually unchanged. No growth in money supply usually means low inflation, even possible deflation ahead. And that may be why suddenly all inflation indicators have abruptly turned down. What is the Fed's reaction to these sudden changes? To continue to tighten the money supply. I'm concerned.

 

In my judgment, Quantitative Easing has had little effect on growth or unemployment. I think QE needs to return to its original purpose: to promote a stable and growing money supply. I'm not a monetarist, but Milton Friedman was right to stress the importance of a steady money supply that grew sufficiently to aid commerce, but slow enough to keep inflation in check. The present Fed is ignoring money in circulation and focusing instead on it's balance sheet, interest rates, and unemployment. In Friedman's book, that's dangerous. I've argued this point strenuously in articles on my site and elsewhere. Suddenly a lot of things are starting to happen that shouldn't be. Perhaps just " a rock" in the road?"

 

All of the trends that were beginning back in July have continued and even gained momentum up to this day. What did the market see?

The imposition of Obamacare and Dodd-Frank with their thousands of regulations was widely expected to cause a reduction in GDP in the first quarter in the US, and did. The adjustment was clumsy and painful. But the 4% initial negative GDP print took the breath away of even the most bearish forecaster. A harsher than expected winter then accentuated the decline in economic activity.

But through an even greater than expected fall of a revised negative 2.9% GDP, commodities rose briskly in the first quarter and beyond. Indexes rose over 20% through the first part of the year looking toward the remaining quarters of expected good growth during the rest of the year. However, by August they had fallen by 10%, even though the US growth rate indeed reversed and was up in the second quarter over 4%.

Everything was going as "planned" with world growth picking up until Russia invaded Crimea. That led to sanctions being imposed, which led to a reduction in world trade, which led to slowing growth. The Eurozone suddenly reversed from higher trends of growth and inflation to lower growth and lower inflation rates to the point of fearing renewed recession and deflation. That spilled over into China, and China slowed. Japan imposed a 6% sales tax, and its GDP which was initially moving higher, fell off the cliff, dropping 7%! That, together with China slowing, reduced world trade and world demand and world commodity prices fell once again.

Then Russia invaded Ukraine and more sanctions were levied, leading to a new round of falling growth rates and prices. The move to end quantitative easing by the Fed reduced money supply at the same time as QE was being introduced in the Eurozone. The result was a divergence of interest rates between the US and most other nations. This caused the currencies throughout the world to fall and the dollar to rise. This put pressure on oil and gas and many other international commodities, and they too fell even as geopolitical tensions increased in the mid-east.

It was a perfect storm and unforeseen by every forecaster at the beginning of the year. Economic growth rates that should have been moving steadily higher fell instead in the Eurozone, Russia, Japan, and China. This reversal nipped the commodity boom in the bud, and led to the present free-fall in most commodity markets. Increased production of many commodities including agriculture and oil and gas has led to prices falling faster and faster. Rising interest rates and a rising dollar has in the last two months exacerbated the decline.

But commodity prices in general are governed by world growth and inflation versus world recession and deflation. Although many stress the importance of interest rates and the dollar on commodities, these are far less influential factors. The reason is that we've seen many instances when commodities have risen with both a rising dollar and rising interest rates, and fall with them as well.

It is mainly when you have an initial steep turn of the dollar or interest rates in either direction that commodities respond inversely to the move. The 5% rise in the dollar in the last 2 months has had an influence on commodities. And the recent rise in interest rates is just beginning to have an effect - hence the continuing sharp fall.

However, once the bond and currency markets stabilize, commodities will adjust and resume their normal trend based on supply and demand conditions.

As a long term investor and a trader in resource stocks, I went "all-in" into precious metals stocks in December of 2013 at $1180 gold. I took profits throughout the run up to $1388 in March, bought back at $1240 in June, and took profits once again as we ran back up to $1340, then sold the last shares I will probably sell this year as gold sold down and broke $1280. I also went short via JDST to hedge the remaining shares I hold. As of today, I covered my short position, taking a nice profit, and am once again on the long side, picking up additional shares of gold stocks.

I will not hesitate to reinstate my short position if gold resumes its downtrend.

The jury is still out as to the degree and duration of this decline in commodity prices, but gold has always been a good barometer of both growth and recession and inflation and deflation. Watch the direction of gold prices and you are likely to know the direction of world growth and inflation rates. And I might add, watch the direction of world growth and inflation rates and you will likely know the direction of gold and most commodity prices.

Post Script

Since the writing of that article, I caught the 1140 bottom of gold and am holding a small core position in junior mining exploration companies. I think the chances are good that we have turned the corner from experiencing a world-wide deflationary/recessionary bias to a growth/inflation bias.

We are seeing the slow turn from deflation in Europe and disinflation in the United States back toward inflation. And we are seeing the turn in both countries from negative or meager growth to higher growth rates. Gold prices have firmed along with most other commodity prices confirming this turn. The year should see a continuing trend upward. If they don't...look out below.

For more see my Market Update at paulnathan.biz

Paul Nathan