While investors eagerly bid stock prices higher in hopes that we are near the bottom of a generational Bull market in equities, the “Smart Money” has been buying gold for the past six years. Most investors cannot wait a year or two to see a return, let alone six, and yet gold prices are not much higher than they were six years ago. Even though gold prices have been flat for the past six years, the “Smart Money” has not been deterred from buying every ounce they can. The reason they are buying gold is also the reason we will be too.
One of the first investments I ever bought was a gold mining mutual fund in the 1990s, as mutual funds cannot buy physical metals, and while this was a positive experience, it did not transform me into one of those investors that thinks every day is a good day to buy gold. My interest in gold has everything to do with the Federal Reserve, the global economy and the global financial system. I believe the Federal Reserve is almost at the end of their monetary magic, and as a result, they will not be able to rescue the global economy from the next recession, which should crush the global financial system.
Most investors believe gold is a hedge against inflation. Gold is a hedge against currency-printing inflation, not consumer-price inflation, which is the type of inflation the Fed bases their monetary policies on. Older investors remember inflation from the 1970s to the early 1980s which was a result of the United States going off the gold standard. The inflation our country experienced after going off the gold standard cannot be repeated, despite the belief of many Baby Boomers who believe currency-printing and consumer-price inflation are about to rear their ugly heads.
The laws of our country prohibit the Federal Reserve, Congress, and the President from printing money. The only form of currency-printing inflation our economy can experience is when the Fed lowers interest rates or engages in a U.S. Treasury bond purchase program, such as Quantitative Easing. Those programs are only temporarily inflationary, since the moment the Fed stops easing, inflation soon stops.
While most investors believe gold is an inflation hedge, the reason it does not fully function as one in the United States is due to the laws that prohibit currency printing. This is also why, despite the Fed’s efforts to create inflation, that they cannot seem to spur inflation after they stop their easy monetary policies. Gold acts as a hedge against central bank policy failure, which is why gold performed so well during and after the Great Financial Crisis and will likely perform well during the next recession.
Fortunately, the Fed had ammunition left in its policy tools to prevent a full meltdown of the global financial system back in 2008-09, but this time, they do not. Typically, the Fed lowers the Federal Funds rate by five percent to end recessions, but with the Federal Funds rate at two-and-a-half percent, lowering interest rates back to zero will have no effect on the economy. This is why the Fed has recently mentioned they now consider Quantitative Easing as a normal policy tool, but it will not save our economy the next time around.
In a debt-based economy such as ours, asset prices fall during recessions. Falling asset prices are a problem as businesses and consumers have borrowed off their inflated assets which means the banks end up holding large quantities of loans on assets that cannot be sold to repay the loan balance should borrowers choose to default. The other problem for banks is they need to boost their reserves to cover the potential loss from a default, which means they stop lending to increase their reserves, or buy large quantities of U.S. Treasury bonds as they have been for the past year. When banks stop lending in a debt-based economy, asset prices fall even further, since asset prices are a function of how much debt is in our economy.
Even though the Fed will lower the Federal Funds rate to zero and implement further rounds of Quantitative Easing during the recession, since Fed Chair Powell recently stated they would, they will have no effect on the economy. While the Fed believes their policy tools will work once again, the Fed will destroy the inflation-creating mechanism in our economy just like the Japanese and European central bankers have destroyed the inflation-creating mechanism in their economies by lowering interest rates to zero and engaging in massive rounds of Quantitative Easing.
The way the Fed will destroy the inflation-creating mechanism in our economy is by driving the Money Multiplier below one, which I believe has happened in Japan and Europe. The Money Multiplier is how many times a currency multiplies itself before dying. Think of it like skipping rocks across a lake. The more times a rock skips, the higher the money multiplier. When the Money Multiplier falls below one, it is like dropping a large boulder into a lake.
The Money Multiplier is algebraically defined as the M2 Money Supply divided by the Monetary Base and is currently at 4.4, meaning every new dollar created is multiplied by 4.4 times before dying. Using the ratio, it is easy to calculate how the Fed will destroy the Money Multiplier during the next recession. Assuming the M2 Money Supply is constant, even though it tends to slightly fall during recessions, the Fed will need to engage in a little more than $11 trillion of Quantitative Easing to drive the ratio to one.
During and after the Great Financial Crisis, the Fed engaged in $4 trillion of Quantitative Easing, so another $11 trillion is not that farfetched when taking in account the dollar’s role in global trade. The U.S. Dollar is the global reserve currency and to properly function, it needs to multiply. Foreign countries will put pressure on the Fed to act should the Money Multiplier hit one, which means the Fed will be forced into massive rounds of Quantitative Easing to reignite the global economy or risk the U.S. Dollar losing its status as the world’s reserve currency.
Given the alternatives, more Quantitative Easing will be the preferred option. It is unlikely Congress will repeal the Federal Reserve Act of 1937, which would lead to hyperinflation of the dollar. It is also unlikely Congress will choose austerity, as 75 million Baby Boomers are due more than $100 trillion of entitlement benefits. Apart from another world war, there is only one option remaining and it explains perfectly why the “Smart Money” has been dumping dollars to buy gold over the past six years.
There is one very simple and easy solution to create inflation that Congress and the President have the authority to do – revalue the price of gold. The last President to revalue the price of gold was Franklin Roosevelt who changed the price the U.S. government would pay for an ounce of gold in 1934 from $20.67 to $35. When President Roosevelt signed the Gold Reserve Act of 1934, he did not increase the price of gold as much as he devalued the U.S. Dollar by 59%. Even though the U.S. Dollar is no longer tied to the value of gold, the official price for an ounce of gold is $42.22.
The benefits of devaluing the U.S. Dollar from the government’s perspective are huge. For example, if the value of the dollar was halved, the value of all debts would be immediately halved. With half the debt to manage, the government would immediately have a positive cash flow that could be spent in the real economy to boost growth. Oddly, this would be one way President Trump could make good on his campaign promise to eliminate the government’s debt in eight years.
Even though President Trump is outspoken about wanting a weaker dollar, the dollar may not need a catalyst to drop in value. The “Smart Money” understands there is an equal and opposite reaction to the economy when the Fed eases and tightens monetary policy. The U.S. Dollar eventually rose in response to the Fed’s monetary easing and with the Fed tightening, the dollar should fall. Due to the massive amount of debt created over the last ten years, currency devaluation may be the only real solution.
Regardless of the motivation, the “Smart Money” has been buying gold and gold mining stocks for the past six years and selling dollars for the past four-and-a-half years. When examining the weekly Commitment of Traders report, a government report that shows the speculative positioning of the “Smart Money” and Hedge-Fund managers, and price charts of both, it is very clear that the “Smart Money” is selling dollars to buy gold.
When the “Smart Money” buys a security, such as a stock, bond or commodity, they have an intended profit target in mind. The longer the “Smart Money” takes to buy up all the inventory of a security, the larger the profit they are expecting. Once the “Smart Money” buys up all the inventory they can, then they begin to mark the price of the security up and tap the financial media to promote interest in the security. As demand for the security increases, along with the price of the security, investors both large and small start to take notice.
From a psychological perspective, American investors prefer to buy any security that is already high and rising. This is why investors tend to chase hot stocks well after they have appreciated in value. The “Smart Money” is well versed in investor psychology, which is how they seem to effortlessly make money once they are done buying up all the inventory of a security.
How high gold will go or how low the U.S. Dollar will go is unknown, as it will depend on how much demand the “Smart Money” can create for gold and how little interest they can create for the U.S. Dollar. The opportunity is not just with the physical metal, but with the mining stocks. Gold mining stocks are a leveraged investment on gold, so when gold rises, mining stocks rise more.
Since there have not been any major gold discoveries in recent years and mining companies have worked diligently to reduce their overhead, along with streamlining their operations, the opportunity with mining stocks is tremendous. Should gold rally, mining stocks will also rally which will allow the large miners the opportunity to leverage their stock to buy up their smaller competitors. This is why the biggest opportunity may be with the junior mining stocks.
The portfolio models are set to take advantage of a Bull marking in gold and gold mining stocks. Fortunately, there is enough trading-volume depth in the junior miners. After all, any time an investor takes a position in a security, they must think about their exit point. When trading volumes are light and a large sale comes in, prices plunge. While I did not intend to sit on the sidelines for so long, the “Smart Money” continues to keep gold prices low in order to flush out the weak players. So far, it has worked their advantage as investors have been dumping gold and mining stocks to buy equities.
The opportunity is soon at hand. Richard Wyckoff, a market technician back in the early 1900s, compiled several price-chart patterns that show when the “Smart Money” is buying and selling. The U.S. Dollar chart is a classic example of a distribution pattern while gold is showing an accumulation pattern. If these chart patterns are correct, the dollar should make a short move higher and gold, along with the mining stocks, should make a short move lower where it will signal a buying opportunity.
Over the years there have been some storied investment managers who have appeared to be doing nothing for year after year, only to make an outsized return in a short period of time that more than makes up for the waiting. While I do not intend to be in that position long term, I have found myself there. But skilled traders will say, the longer the accumulation pattern, the bigger the upside return. Looking back in history, I have not found a chart pattern showing an accumulation pattern as long as the one seen in gold today.
Given the likeliness that the Fed will lose control of monetary policy during the next recession and with debt levels at astronomical levels, a currency devaluation seems extremely likely. As far as upside potential, the “Smart Money” expect to make a high enough return to offset their time. Had the “Smart Money” bought the S&P 500 instead of gold in July 2013, they would have realized an 83% return, which means they will be looking for a larger return to make up for their time.
If the junior mining ETF (symbol: GDXJ) goes back to its prior all-time high that was set back in December 2010 from where it is trading today, the return would be in excess of 400%. For most investors, it would take nearly thirty years of investing in a broad equity index to match that return. Revisiting its 2016 highs would mean a 60% return from where it is trading today, which is still better than being in the broad stock market for the past few years.
Opportunities like this do not come around very often, especially when most investors have a large lump sum compared to what they had years ago. Now you know why the “Smart Money” is buying gold, and why we will be buying gold mining stocks when they make their final bottom.
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