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Wednesday, February 23, 2011

Gold-Stater gold market comment Feb 24, 2011

Gold and oil are clearly moving together right now in response to the ongoing Mid East crisis. Gold crossed $414 as crude crossed the $100 mark.

As per usual, theories abound. The theory most bandied about is that gold moves with oil because rising oil is inflationary and gold is an inflation hedge. Both propositions are wrong.

First, rising oil can be inflationary when it is rising because of industrial demand in an expanding economy. In a sluggish economy with wide spread unemployment, such as we are now experiencing, rising oil is deflationary. This is because every cent oil rises is a cent taken out of consumer discretionary spending. In fact for every dollar oil rises, the economy is depressed by a factor of between 90 and 100 billion dollars. Yes that's billion. Massively deflationary.

Second, Gold can serve as a hedge against inflation, but then during periods of inflation almost any commodity will serve as a hedge. Oil, cotton, copper, sugar, lumber, etc. So then why are we seeing reversals in many of the commodities? Copper had an outside reversal day two days ago and continued to fall yesterday as gold and oil rose.

The fact is that oil is rising right now not because the economy is recovering but because the oil producing states of the Mid East are going up in flames - as anyone can see. Gold is going up because the world economy is oil dependent (addicted if you like), and when the supply of oil is disrupted the world economy will experience tremendous deflationary pressures.

So does that mean gold is a deflation hedge? No! Gold is a monetary instability hedge. Why? Because gold is a stable currency. It is a currency because the Central Banks of the world use it as such. It is stable because it cannot be printed at will.

Therefor, we see, in this case, gold and oil are rising together, but for different reasons. Do they often rise together? Yes! Do the always rise together? No! See the chart above.

This little exercise points out the futility of reversion-to-mean theories. They work when the variables upon which they are created are constant. They don't work when the underlying conditions in the real world change.

Nassim Taub destroys the fallacy of Reversion to the Mean theory in his book the Black Swan. His idea is that Black Swan events - extraordinary events - occur regularly. So regularly, in fact, that they constitute the norm of human experience. It's just that each one is different.

Few people foresaw that the Mid East would go up in flames right at this point in time. But everyone should have expected that something would happen to rock the world economy. The question is always this: How stable are current economic conditions in the face of the next Black Swan Event. Everyone should have foreseen that the answer to that question, is: Not Very Stable.

How unstable are current economic conditions? Interest rates, at Zero, are functionally negative. Bank balance sheets are still largely unrepaired except for the illusion of mark to model accounting. And the Fed is carrying trillions in bad debt on its balance sheet. Real unemployment is at about 20 percent. The Federal deficit is over 14 trillion dollars ( not counting another 70 trillion of unfunded liabilities) while the US consumer is 11.4 trillion dollars in debt.

How extreme is this Mid East black swan event? Who knows. We'll soon find out.

But count on this: gold has only just begun to rise.

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