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Could a central bank ever be a force for good?

The following paragraph from John Hussman's latest weekly letter is brilliant. It explains, as succinctly as it is possible to do so, why the actions taken by the US Federal Reserve have generally been counterproductive.

"The standard of living of a country is measured by the amount of output that individuals are able to consume as a result of their work. The productivity of a country is measured by the amount that individuals are able to produce as a result of their work. Over time, growth in the standard of living is chained to and limited by growth in productivity. Productivity, in turn, rests on two factors: a productive capital base, and an active pool of productive domestic labor. The accumulation of productive factors is what drives long-term growth. When the most persistent, most aggressive, and most sizeable actions of policymakers are those that discourage saving, promote debt-financed consumption, and encourage the diversion of scarce savings to yield-seeking financial speculation rather than productive investment, the backbone that supports a rising standard of living is broken." [Underlining added]

However, the same Hussman letter contains the following wrongheaded comment:

"...deficit spending and monetary stimulus can be appropriate as a sort of short-run "kindling" to ease constraints on the economy that would otherwise be binding."

Many of the people who understand the problems that have been created over the past 14 years by the Fed and other central banks unfortunately believe that a central bank could be a force for good if only it were run in a prudent manner. This belief is misguided for three main reasons.

First, there are never any constraints on a free economy that could be eased by deficit spending and monetary stimulus. The constraints that could supposedly be addressed by some form of artificial stimulus only arise due to the creation of money out of nothing by the central bank or the commercial banks. This is a practice that either could not happen (there would be no central bank) or would not legally be able to happen (it's unlikely that counterfeiting by banks, a.k.a. fractional reserve banking, would be condoned) in a free economy.

Second, fiscal and monetary stimuli always lead to bigger problems than the problems they are supposed to address. This is because an increase in government spending necessarily involves greater government theft and politically-motivated wealth transfers, and because monetary stimulus always generates false price signals that ultimately make the economy less efficient. Policies that bring about undeserved wealth transfers and get in the way of genuine price discovery cannot possibly help under any circumstances.

Third, if a central bank is given the special power to inject money into the economy and manipulate interest rates under certain conditions, such as during a banking crisis, the power will eventually be abused to the point where the central bank comes to dominate the economy. It is an inevitable transformation that is bound to occur regardless of whether the central bank is government-owned or privately-owned. The only unknown is how long it will take. In the US it took 95 years, if we mark 2008 as the year in which the Fed came to totally dominate the economy.

Further to the above, the idea that a prudently-managed central bank could be a net benefit to the overall economy is naive, to put it mildly. It is akin to the belief that the only reason socialism has never worked is that the right people haven't been in charge.

Sentiment and momentum extremes

The Stock Market

The S&P500 Index (SPX) reversed lower last Friday and declined over the first two days of this week. It then rebounded from short-term support at 1976-1980 on Wednesday.



The SPX is currently down by only 1% from its all-time high and is yet to breach any support of significance. It therefore wouldn't surprise us to see it move to a new all-time high within the coming fortnight. At the same time, the bearish divergences and non-confirmations are continuing to pile up. For example, Wednesday's rally by the SPX to within 1% of its all-time high was accompanied by 221 new 52-week lows by individual stocks and only 49 new 52-week highs by individual stocks across the NYSE and NASDAQ markets.

The current overall situation in the US stock market suggests that the SPX could make a new all-time high within the next two weeks, but that any new high will be marginal and will not be confirmed by market internals and many other equity indices.

Gold and the Dollar

Gold and Silver

Gold relative to silver during precious-metals bull markets

It is widely believed that silver outperforms gold during bull markets for these metals, but that's only partially true. It's true that silver tends to achieve a greater percentage gain than gold from bull-market start to bull-market end. It's also the case that silver tends to do better during the final year of a cyclical bull market and during the late stages of the intermediate-term rallies that happen within cyclical bull markets. However, the early stages of gold-silver bull markets tend to be characterised by relative strength in gold. This is a point we've made in the past, including in TSI commentaries earlier this year, but warrants revisiting due to the recent price action.

The point we are trying to make is established by the following long-term chart of the gold/silver ratio. The boxes labeled A, B and C on this chart indicate the first two years of the cyclical precious-metals bull markets of 1971-1974, 1976-1980 and 2001-2011, respectively. Clearly, gold handily outperformed silver during the first two years of each of the last three cyclical precious-metals bull markets that occurred within secular bull markets. Therefore, while silver's recent weakness relative to gold certainly doesn't guarantee that a new cyclical bull market began last December, it is not inconsistent with our view that a new bull market began at that time.



The above chart indicates that this year's continuing upward trend in the gold/silver ratio (continuing weakness in silver relative to gold) is not in conflict with the view that gold commenced a cyclical bull market last December and is working its way through a lengthy basing process. But what about silver's recent break to a new bear-market low in US$ terms? Does this negate the cyclical gold bull market view?

The answer is a qualified no. Silver's breakdown is definitely not, in itself, a reason to believe that the metals are immersed in an extended basing process, but it is also not unprecedented for the early part of a cyclical gold bull market. As evidence we present the following chart showing how gold and silver performed during 2000-2004. Notice that gold made its ultimate bear-market bottom (and commenced a new cyclical bull market) in February of 2001, but silver didn't make its ultimate bear-market bottom until November of 2001.

Silver's performance in November of 2001 is another example of a long-term decline ending soon after an important support level is breached.



Current Market Situation

The gold price broke below support defined by its June low during the week before last and hasn't yet signaled an end to the short-term downward trend.

It's worth noting that the US$ gold price has just accomplished another "death cross" (the 50-day MA has crossed from above to below the 200-day MA). Death crosses often occur near short-term price bottoms, and despite their name are therefore usually bullish. For example, gold's previous "death cross" at the end of May turned out to be a short-term bullish signal, as we said at the time would likely be the case. However, when there is a "death cross" followed by a "golden cross" followed by another "death cross", as per the current situation in the gold market, the second "death cross" is not a reliable bullish signal. This doesn't mean that gold is not very close to a short-term bottom; it means that the "death cross" of the past few days doesn't constitute evidence of an impending price bottom.



Gold will probably begin to rally soon -- if not this week then in early-October. However, if the fundamentals don't start moving back in gold's favour then any rally over the coming 1-2 months will be within the context of the drawn-out basing process that got underway in June of last year.

For the fundamentals to start moving back in gold's favour, the S&P500 Index will probably have to start trending downward.

Gold Stocks

The following chart shows that the HUI is testing lateral support defined by its early-June low. The chart also shows that the GDXJ/GDX ratio took a hit on Monday due to substantial relative weakness in GDXJ, but that the bullish divergence between the HUI and GDXJ/GDX that began to develop in early-September remains intact.

As is the case with gold bullion, the gold-mining sector will probably begin to rally soon. But as is also the case with gold bullion, there is not yet any evidence that a short-term price bottom is in place.

With regard to the price action that would constitute evidence of a short-term price bottom, we have some specifics in mind, but the numbers change every day based on what happened that day. Suffice to say right now that as long as the bullish divergence between the HUI and the GDXJ/GDX ratio remains intact, it won't take much strength from here to signal a multi-week turn to the upside.

Updates on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html