THE VALUE VIEW GOLD REPORT
MONEYization #24

Ned W. Schmidt, CFA, CEBS
May 25, 2006

Or, It is what it will buy.

Motivations for today's writings are two events, one large and one small. The first of those was the report on consumer prices for the month of April 2006 in the United States that was released on Wednesday, 17 May. Subsequent to that release, paper equities took a horrible slide. Gold and Silver followed those markets lower. These market reactions seemed to surprise almost all.

Second, a letter to the editor in a popular business publication caught my attention. The writer had clearly ended the week poorer due to owning paper equities. His lament was apparent in his question. He wanted to know why stocks went down if equities were a hedge against inflation. This inquiry is not rare, and shows a lack of understanding of the fundamental theory of paper equity valuation. This statement is not meant as a criticism of the writer but rather the general state of understanding of how financial equities are valued.

That inflation, wherever one lives, is generally higher than reported by government agencies is generally accepted. The statistical garbage on inflation put out, for example, by the U.S. bureaucrats is perhaps worthy of some special award. Oh well, we are all stuck with our individual governments. However, we don't have to confine our lives to either their statistics or the fiat money produced by their central banks.

Since most of us consume both petroleum and food, the headline number on the U.S. CPI is most relevant. The first graph portrays the year-to-year change in the total U.S. consumer price index over the past ten years. That the rate of U.S. inflation has broken out of the ten-year trading range is fairly obvious. More important, little evidence exists to suggest any moderation of a material nature in this measure of inflation

First Graph

As we know, the policy makers in the U.S. are addicted to the statistical nonsense of core inflation. As they probably travel to work in government furnished limousines and eat in government-subsidized cafeterias, that is probably a reasonable view for them to take. Indications that the core rate of inflation in the U.S. is likely to move up can be found. For example, consider the second graph.

Second Graph

The second graph is of the median CPI calculated by the economics research group at the Cleveland Federal Reserve Bank. In calculating the CPI various individual components are created representing various categories of goods. Food and energy are clearly the most well known. A median is the value that divides the sample into equal components. Half of the components are rising more than the median and half are rising less than the median. Median measures are less influenced by extreme values as is the case with the common average or a weighted average

What may have spooked the financial markets is that such measures as this appear to have broken out to the up side. Notice how this inflation measure has penetrated the 2.5% resistance level. The consensus forecast in the financial markets, and with many of those deluded individuals running U.S. monetary policy, was that inflation was low and/or moderating. Reality has a way of trashing consensus estimates. With this development, expectations of lower interest rates faded rapidly. In the short-term, the Federal Reserve is motivated to raise rates again. In the longer term the Federal Reserve will continue to have a preference for easy money, which is why so many of us prefer Gold to fiat monies.

Equity markets quickly reacted to this change in the outlook. What was not expected by many was that this sell off would spill over into the precious metals and other commodities Markets are financially connected, and that is more true today than ever before with hedge funds dominated trading. To understand the connection, imagine one giant margin account that owns equities, metals and commodities. If the stock component declines in price, the equity in the account shrinks. The margin account will need to reduce overall market exposure. To accomplish that, metals and commodities were sold. Surprisingly, in this situation inflation hedges go down with higher inflation expectations. Note that this is definitely a short-term situation, and that it may repeat itself many times until the hedge fund monster is decapitated.

The recent sell off in many commodities and precious metals has encouraged many of the paper asset groupies. Caution is appropriate here. Leveraged buying by hedge and commodity funds had pushed many commodity and metal prices well above their trend. This "price fluff," while making us all feel good, was artificial and doomed to ultimately disappear. That "price fluff" has now been largely eradicated. While an immediate renewal of the uptrend for all is unlikely, the bull market in Gold and Silver remains intact. The price of Gold is determined by inflationary monetary policy, not copper and zinc prices.

Before moving on to the second question, let us reflect on the recent record of inflation about which so many analysts and economists applaud. Many have commended the inflation record of the Federal Reserve. Reality is a lot less kind. For the sake of discussion, let us consider the CPI less food and energy. The moderate rate of increase in this measure is in reality like being a little bit pregnant. A low rate of "inflation" simply means that the purchasing power of the money is being destroyed at a moderate rate. Purchasing power is still being destroyed.

third graph

The third graph shows the purchasing power of a dollar based on the CPI less food and energy. As is readily apparent from the graph, a U.S. dollar of today buys only about 80% of what it did ten years ago. 20% of its purchasing power has been destroyed. Federal Reserve policy, if one were to accept the CPI less food and energy as meaningful, has been effective only if one believes that reducing the purchasing power of your dollars by about 20% is commendable. Those holding U.S. dollars should realize that the Federal Reserve has, one, not maintained the purchasing power of the dollar, and, two, has no intention of doing so in the future.

The free market price of Gold should reflect any reduction in the purchasing power of national monies. For that reason so many over the years have moved their liquid wealth to Gold from their national monies, the moneyization process. Gold is inherently an inflation hedge while paper equities are not, as discussed below. Gold is efficiently priced in a free market to reflect purchasing power of every national money. That process does not happen with paper equities.

In the fourth graph has been added the purchasing power of $Gold, again using the CPI less food and energy. The results are quite pleasing for those that have held Gold, and as was previously observed unpleasant for holders of U.S. dollars. As we know, the unfavorable periods in the 1990s was when central banks were leasing and selling excessive amounts of Gold. That activity was curtailed in 1999 when European central banks realized they were hurting themselves by doing so.

fourth graph

The second question mentioned at the outset was that investor's concern for the merits of paper equities as an inflation hedge. That misunderstanding is quite common. This view stems from those occasional periods when the real, inflation adjusted, value of equities has risen. No theoretical reason exists for equities to provide a total return in excess of inflation. They can, but not necessarily and certainly not for all stocks.

Space prevents the full exploration of the derivation of the following equation, but we promise to do so in another article. The value of any investment is the present value of the future cash flow to be generated by that investment. The value of a stock is, therefore, the present value of the near infinite stream of dividends to be paid in the future by the company. To save time and space, the value of that series converges on the value in the following formula. All values in the denominator are decimals.

Inflation enters that formula in two ways. First, it raises the discount rate. That flow through is near immediate in today's world. k rises, and the value of the stock declines. Second, inflation may increase the growth rate of dividends over time if companies are able to increase their prices faster than inflation. No guarantee exists for this latter process. Paper equities can be in some periods of time inflation hedges, however, do not count on that happening. Due to the way the value of a paper stock is determined, the expectation of them being an inflation hedge is likely to be disappointed.

Gold is indeed the superior inflation hedge, but it still trades in a market. At the present time the markets are unwinding excessive short-term pessimism on the U.S. dollar and over enthusiasm for commodities. These conditions had pushed both Gold, and Silver, to over bought conditions that had persisted for weeks. Funds that previously bought heavily in all commodities have been scaling back those positions. Opportunities are being created in the Gold and Silver markets as a consequence of this selling.

This retreat of speculative funds has broadly impacted commodity prices. That selling will diminish in impact as time passes. The underlying demand for individual commodities and metals will then again dominate. In some cases, this support may come at lower prices. The dominant component of demand for Gold, and Silver, is investor demand which does not exist for other metals and commodities. While investors may hoard Gold in their safety deposit boxes, few will likely put a ton or two of copper or zinc in their basement.

This summer could be one of some long lateral patterns in both Gold and Silver. The World Cup, 9 June to 9 July, will likely make all global markets somewhat more illiquid this year. Multiple buying opportunities will be created, as the last two charts suggest. Those buying opportunities in Gold should not be ignored. The inflationary tendency of central banks continues to destroy purchasing power. Price corrections will occur, and investors should take advantage of these buying opportunities so that they are on board for the ride to over US$1,300. Charts for Euro Gold and GDM also available.

Ned W. Schmidt
Ned W. Schmidt, CFA,CEBS is publisher of THE VALUE VIEW GOLD REPORT. That report nowincludes a weekly message, TRADING THOUGHTS, to help investorsidentify timely points for buying Gold and Silver.

You can join him for the Gold Super Cycle here.

His monumental report, "$1,265 GOLD," with 255pages and 98 graphs, is now widely known, and is available atwww.amazon.com or from the author. This work has nowbeen read by investors in over twelve countries.

Ned welcomes your comments and questions. His mission in lifeis to rescue investors from the abyss of financial assets andthe coming collapse of the U.S. dollar. He can be contacted atnwschmidt@earthlink.net.

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