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Published 7/06/05
Two recent forecasts about the price at which gold will equal the DJIA
spurred the Optimist's creative nature, and he wants to share the results
with you. As background, the inimitable Richard Russell guesses that gold
will rise and the Dow will fall so that their price levels will cross in the
2,000 to 3,000 range. The noted Swiss banker Ferdinand Lips also guesses that
the Dow and gold prices could cross at 3,000, but he adds that they might
cross at 20,000 in an environment of hyperinflation. With all due respect to
both of these illustrious gentlemen, the Optimist hopes that they are far too
pessimistic. Since the Optimist has chosen the path of perpetual Pollyanna,
he feels a solemn duty to offer a much brighter perspective.
The following is NOT investment advice! The Optimist will be as
surprised as everyone else if the projections below approximate the way real
events will unfold in the future. This is only an exercise in projecting a
possible progression of prices under the stagflation environment which the
Optimist supported in Stock and House Prices Might Not Fall Off a Cliff. Think of
this work as entertainment for precious metals bulls, and slow water torture
for both bulls and bears on the stock market.
As indicated in his previous commentaries,
the Optimist believes that the USA economy is currently in a stagflation
where prices rise relentlessly, but the nation's employment base is eroding.
The economic environment of 2005 is remarkably similar to that of 1975, and
the progression of stagflation over the next few years could continue to
track the escalating stagflation of 30 years before. In This Time, It
Really Is Different!, the Optimist argued that the Fed will be
constrained from using the high real interest rate approach it took to stop
rising stagflation in 1980. The logical conclusion is that stagflation will
continue to increase at ever higher rates for the next decade or more. While
the possibility always exists of an abrupt encounter with a massive iceberg
as the good ship USS Economy sails through stormy seas, such an event is
unpredictable and the results from a collision are far from certain. This
commentary will assume that there is no cataclysmic financial accident in the
next decade, and that the USS Economy will continue uninterrupted in its
course through ever worsening rough seas.
A brief note about inflation is in order before the projected data is
presented. As discussed in $100 Oil
Solves the Wrong Problem, the Fed has a strong arsenal of weapons it
can use to moderate the rises reported in the official CPI. The Optimist is
happy that he can offer the positive perspective that the CPI data from
Washington will show inflation increases at less than double digit levels
through the next decade. For the purposes of this essay, however, the
Optimist includes the likely impact of much higher prices of food and energy
as if they were real issues that actually affect people's finances, and he
ignores the abundance of hedonic opportunities which the Fed can employ so
well. Thus, the Optimist's guesses about the level of inflation reflect the
real cost impact that he anticipates consumers could feel in their wallets.
 
The format of the data
Even though everyone knows that the Fed controls the economy, and the Fed
is an independent organization, the Optimist highlights the presidential
election years in light red as if politics had some bearing on prices and
performance of the markets. Even the Optimist cannot pretend there will be no
more recessions, so he colors in light blue a possible recession,
coincidentally beginning immediately after the 2012 presidential election.
With the rest of the data on a white background, the Optimist is pleased to
show his patriotic fervor by presenting the data in shades of red, white, and
blue! The one exception is that the Optimist cannot conceal his joy at
identifying no less than six new annual highs in the Dow through 2016, and he
highlights those highs with bright green. With wildly bullish guesses of six
new stock market highs in a decade, it is easy to see how the Optimist earned
his name!
The columns to the right of the projected market highs show values relative
to 2004 after adjustment for subsequent inflation. The Value column
demonstrates the miracle of compounding by showing the value that remains
after the annual inflation.
Inflation
Stagflation presupposes significant levels of inflation, and the Optimist
is happy to comply with those rules. Although his guesses for inflation are
consistently higher than the levels our economy has previously experienced,
they are still moderate in comparison to some who suggest that hyperinflation
is a prospect in the not too distant future. A quick search of the internet
shows that hyperinflation can get as high as hundreds of per cent per day.
The Optimist is hopeful that we will not visit those elevated levels of
hyperinflation for many years. The Optimist also forecasts a 50% reduction in
the rate of inflation during a recession in 2013 - 2014. The Optimist is
happy he can show his support for the Fed as they do battle with real
inflation after the 2012 elections.
Stock Market
The Optimist is very confident that his projections for the highs in
stocks, gold and silver for 2004 will be proven to be approximately correct,
but he is less certain about the indicated highs for 2005. After that, his
crystal ball is temporarily not working well so subsequent highs are really
only guesses to illustrate the trends he considers possible. The Optimist
believes that a sharp drop in the stock market is not politically correct,
but that reduced profit levels and the stagnation in the economy will make
substantial price advances unlikely too. Although a real effort to constrain
inflation could temporarily lower stock prices by a third as indicated in the
recession of 2013 - 2014, the Optimist concludes that stocks which are not
permitted to decline will repeatedly rise to new highs over the next decade.
That would obviously be bad news for the bears, but the bulls who cast an eye
on their value adjusted returns may also be less than overjoyed. During
consistently rising inflation, the stock market might not be the best sandbox
for kids to play in.
Gold
Even though the Optimist has learned through experience that making
predictions is a humbling process, he boldly offers his view of how the price
of gold might progress during high and rising inflation. Time will tell
whether this boldness is a reflection more of confidence in his viewpoint or
of his inability to learn from his past errors.
As clearly demonstrated in the 1970s, gold responds enthusiastically to
rising inflation in a stagflation environment. In many places and over a multitude
of centuries, gold has proven its ability to retain value as fiat currencies
deteriorate over time. Owning gold has long been considered as the ultimate
insurance policy against problems caused by escalating inflation. While it is
true that gold pays no interest, we learned in the 1970s that earning a few
percent interest was little consolation as real inflation decimated a higher
percentage of the investment.
At first glance, all readers will consider the guesses for the prices of
gold to be outrageously high. A second look at the inflation adjusted values
will provide a more sobering viewpoint. After gold values escalate with the
price momentum over the next few years, the recession of 2013 - 2014 could
return the inflation adjusted value of gold to a level below its highs in
2004. The questionable assumption in this data is how high the real rates of
inflation will be over the next decade. If the indicated guesses for real
inflation are close to reality, then gold prices really can advance as rapidly
as shown.
Silver
Silver is an intriguing metal. It has so many uses that it is being
consumed by industry at a faster rate than it can be mined from the ground
and recycled from previous uses. Although there were billions of ounces of
bullion silver in government warehouses just a few decades ago, those
warehouses are now empty. It seems likely that there exists less than a few
hundred million ounces of bullion silver remaining in other warehouse stocks
to be consumed at the lowest cost for silver. As those stocks become more
depleted, the value of silver must rise to give private holders of bullion,
coins and jewelry an incentive to feed their silver into the industrial
silver consumption machine. In addition to the value which must be added for
depletion of supply, silver prices will also respond aggressively to the
price pressures generated by rising inflation.
An interesting sidebar is that the table shows both nominal prices and
real adjusted values of silver to continue rising through the projected recession
of 2013 - 2014, even though demand for silver would likely slow somewhat
during a recession. That price advance would occur because much of silver's
production is a byproduct of copper and zinc mining. In a recession, the
prices of copper and zinc could drop close to or even below the cost of
mining, so the mine output would be substantially reduced. That in turn would
also reduce the amount of byproduct silver which is dumped on the market.
Total silver supply would decrease faster than demand would drop, and so a
recession would actually increase the price pressure on silver.
Another point to consider is that silver is actually being consumed by
industrial processes around the world at a faster rate than it can be mined
from the earth, so the above ground total supply of silver diminishes daily.
Gold, in contrast, has less destructive consumption, so most of the newly
mined gold adds to the above ground supply in the forms of bullion,
collectibles, jewelry, etc. If that trend continues, silver will be less
plentiful than gold. The combination of relative scarcity and industrial
demand pushed platinum to much higher prices than gold, and it can do the
same for silver.
As a final note on silver, this hypothetical set of price and value trends
does not try to forecast the dislocations that are inevitable when
manufacturers who need silver panic to buy the limited supply, or when the
commercial interests who are massively short silver futures and options are
finally forced to cover their short positions. Each of those events could
rocket silver prices higher by orders of magnitude, and stair step the
progression shown in the table to much higher price levels. Once again, the
Optimist demonstrates his perpetually positive nature by cheerfully
forecasting that silver could be more expensive than gold when the price of
gold rises higher than the DJIA in the years ahead.
Housing and interest rates
Conspicuous by omission are forecasts for housing and interest rates. They
are not in the table because the Optimist does not want to waste readers'
time with random thoughts that he has no strong basis for discussing. Some
readers will inevitably ask about those important topics, however, so the
Optimist will close this commentary with ballpark guesses. The current average
cost of the typical suburban house can be estimated to be twenty times the
DJIA. Even though real estate is currently over priced and in a bubble, it is
likely to outperform stocks in an environment of high and rising inflation.
That same typical house could rise to a higher multiple of the DJIA over the
next 12 years. Even considering the possible rise compared to the DJIA, fewer
ounces of gold or silver will be needed to purchase in 2016 the equivalent of
a house which now costs 500 ounces of gold. A word of caution is necessary
for any reader who dreams of buying a bunch of houses at no money down to
capture some of the increase in equity. First, the Optimist could be wrong
(it would not be the first time!), and house prices may not rise. Second, many
undercapitalized buyers will find they cannot survive the crunch caused by
rising demands for cash flow, and they will be forced to sell at a loss.
Third, rising unemployment will cast a pall over the housing market, and
there is likely to be a shortage of greater fools to fulfill their destiny as
buyers when the owner needs to sell his house.
The Optimist confesses to profuse confusion over the current low and
falling long term interest rates. In the 1970s, few things were more certain
than that long bond rates would climb higher each time that inflation growled
louder. Now, it seems like long term interest rates drop each time real
inflation pushes prices higher. If that strange trend continues, one wonders
if long term interest rates could drop toward zero when inflation rises in
double digits! Once again, the Optimist cautions trusting readers to not use
this viewpoint as investment advice!!
A reader comments (posted on 7/10/05):
Allow me to provide a rosy outlook for long bond holders. [I suspect
that, like US stocks, US bonds are not permitted to fall in price.] Should
Asian Central Banks cease their purchases of US bonds, the US Federal Reserve
will be happy to fulfill its obligation as "lender of last resort"
(to the Government, silly, not you) by buying all bonds the US Government
cannot foist on anyone else. [Indeed I'm pleased to declare that this is
already happening, witness this chart of Federal Reserve treasury holdings:http://www.gold-eagle.com/editorials_05/image...away070105f.gif(from
this article http://www.gold-eagle.com/editorials_05/ha...away070105.htmlwhich
notes that foreign CBs were net sellers in March & April).] Since
vigorous buying of bonds by foreign and then domestic CBs drives long bond
prices up and yields down, and will continue to do so throughout the rising
tide of US "liquidity", I see no reason to fear that long-term
interest rates will go up ever again.
The US Federal Reserve may end up having to own all outstanding bonds.
In those future mightily-replicated and -devalued dollars the bonds will
actually be worth a few pennies. But, after a century of us all being obliged
to pay interest to the Federal Reserve for borrowing money it could
mass-produce for pennies, it is only fitting that the US Federal Reserve
should sink under its own "liquidity", and sink with the Government
it pretends to be, and end up once again owning only some pennies. So I view
this outcome as miraculous poetic justice.
A reader comments (posted on 7/20/05):
I manufacture Electronics. Here in Europe we have something called the
RoHS directive. The directive requires that end-customer electronics for
Europe should be manufactured using lead-free solder. Referring to your
estimation on a significant higher price for Silver, I note that most
lead-free solders currently include approximately 3.5% of Silver. I don't
know how much Silver would be needed to cover the fraction of solder that will
be used in lead-free production. But it could end up to an extra demand of
200 to 600 metric tons annually. That could be about 2% of world Silver
production. Sorry, I don't know much on the Silver market, so I can not say
if 2% is the correct number, or if it is a large or a small number!
The Optimist:
Many thanks for a most interesting data point. It seems like the uses for
silver expand almost daily, and the amount of silver available to satisfy the
demand continues to dwindle. Unless some bright alchemist can quickly develop
a way transmute lead into silver, a silver price explosion is inevitable, and
it is likely to be sooner rather than later. For readers who are not well
aware of the awesomely bullish state of the silver market, I recommend reading
all of target="_blank"the articles written by Ted Butler. Of special
note is target="_blank"the July 12, 2005 article titled You DO The Math
in which Mr. Butler clearly stated that there is already less silver in the
world than there is gold. An equation in which there is less silver than
gold, raised to the power of silver being consumed rapidly by industry, can
only yield the result of much higher silver prices in the future.
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