Why the Gold Bugs Got it All Wrong

Originally published on August 5, 2013 (August 2013 Intelligent Investor, Part 1)

The correction in the commodities bubble continues to be driven by weak economic growth. Similar to other assets traded on an open market exchange, commodities pricing is determined primarily by supply-demand characteristics.

Although commodities pricing is primarily a reflection of demand for raw materials required for economic growth, other variables influence price dynamics, such as inventory levels and everything that might alter inventories, such as weather conditions, or in the case of crude oil, geopolitical events.

We want to reemphasize our view that the current global economic weakness is likely to prove as a stronger force on commodity pricing than the effects of quantitative easing.

This reality caught every gold bug and many commodity bulls by surprise. Although many of these individuals had been bearish on the global economy, they overemphasized the inflationary effects of quantitative easing.

As a result, they were predicting soaring commodities pricing throughout the correction, or since early 2011. Their main error was that they failed to realize that excessive inflation is a virtually impossibility when interest rates are near zero and unemployment is high. But these are basic concepts from macroeconomics 101.

As well, they made another ridiculous error in assuming an increase in money supply is always associated with inflation. This is only the case when banks redistribute the money directly to consumers.

Inflation is NOT defined as an increase in money supply because an increase in the money supply does not necessarily cause prices to rise. Inflation is properly defined as an increase in the price of goods and services. And since consumers influence the majority of economic activity, it is only important to determine whether consumers are encountering inflation.

While certain segments of the economy have experienced excessive price increases, such increases have been largely independent of quantitative easing and/or low interest rates. For instance, healthcare and education costs have been rising at a rate that is two to three times greater than economic growth in the US for more than a decade. The rapid rise in the costs of these items is complex and related to industry dynamics.

As well, the rise in energy pricing is more related to deregulation (for electricity and natural gas) of the industry and the wars in Iraq and Afghanistan (for crude oil) than low interest rates. Meanwhile, the increase in food pricing has been somewhat associated with other factors such as high fuel prices, crop shortages, ethanol mandates, etc. That said, elevated food prices have been the item most associated with real inflation.

When secondary components are factored into the commodities pricing equation such as weather conditions, stockpile estimates and other variables that impact supplies, it can be a very difficult task to predict commodities pricing.

This is a point that we have made in the past and has for the most part proved to be true. It is obviously of great significance because so much of the price volatility in commodities is based on daily news regarding weather and how it is expected to affect crops and related commodity products.

Finally, we cannot forget that the commodities market is similar to all other markets in that a good deal of price manipulation occurs. Sometimes this manipulation is sufficiently excessive that it temporarily dwarfs all supply-demand dynamics.

We cannot know in advance what amount of price manipulation might occur. It is even difficult to estimate the impact of the global economics on commodity pricing since it is very difficult to obtain an accurate picture of the global economy, both from a current and forward-looking perspective. The fact that the IMF, OECD, Wall Street and other economists and analysts have consistently missed economic growth forecasts confirms the difficulty in this task.