Why Black-Owned Stocks Should Be Concerned About The Price Of Gold
As we have indicated in this space before, the price of gold is the best indicator of a monetary inflation or deflation. Or, as Jude Wanniski, head of the economic forecasting firm, Polyconomics Inc., puts it: "The best index to use as a guide to the dollar, and whether it is inflating or deflating, is the dollar price of gold…It is the proxy for all goods and services, present and future whereas the wholesale and consumer price indices track only current prices. Gold, in other words, embraces the dollar valuations of goods and 'bonds', i.e., financial assets. In this sense, the world is now and has been on a gold 'standard' by which the markets assess the shifting relationships of paper currencies against the premiere monetary commodity."
Once a gold price is established that represents equilibrium for the supply and demand for dollars, every human being, entrepreneur and corporation can watch the price of gold in order to determine whether an inflation or deflation is in progress.
For example, if a gold price of $300 an ounce is determined to be that equilibrium price, if the price of gold drops to $295 an ounce, it is evidence of a monetary deflation and if the gold price rises to $305 an ounce, it is evidence of a monetary inflation. At $300 an ounce, the exact supply of dollars is in circulation to satisfy the demand for dollars. At $295 an ounce, less dollars are in circulation than are necessary to satisfy the demand for dollars and at $305 an ounce, more dollars are in circulation than are necessary to satisfy the demand for dollars.
It is in this sense, Wanniski explains, that the dollar gold price serves "as a pure signal of the economy's demand for dollar liquidity- currency and bank reserves".
Wanniski is not alone in his reverence for gold and its utility in the marketplace.
Coming from another angle, CNBC's premier business journalist and anchor Ron Insana also subscribes to the belief that the price of gold is a premier monetary signal. In his book, The Message of The Markets, he writes:
"To this very day, despite the doubts of economists, gold has been sending accurate signals about the prospects for inflation. Since 1985, gold prices have been cut in half again, reaching a low of $250 per ounce in the summer of 1999. Inflation rates, meanwhile, have moved steadily lower ever since. The correlation between gold prices and inflation is still remarkably tight. While many pundits have suggested that gold's link to inflation is dead, it's quite obvious that that is simply not true. Gold may have a reduced role in the world economy. It may no longer be a viable currency. But since gold is a commodity that remains quite sensitive to fluctuations in the value of paper currencies around the world, it's not yet time to ignore the message of this (gold) market."
He also writes, "The price action of gold told investors that inflation was an intensifying problem throughout the 1970s and had peaked in 1980. Had any investors or consumers been paying attention to gold's price, they would have profited handsomely in both environments".
The "price action of gold" as Mr. Insana calls it, has one of its greatest utilities in the signal it provides the financial markets and investors, in particular, of whether or not a sufficient amount of dollar liquidity is being supplied.
Companies, which offer shares of their stock on various exchanges, hope that their company is on the receiving end of this dollar liquidity as investors, of the institutional and individual variety, trade their financial capital for claims on future earnings or shares of ownership of a company. This can only take place, at an optimal level, if sufficient currency and bank reserves are supplied by the Federal Reserve to satisfy the demand for dollars.
This is especially true for firms with smaller market capitalizations, so-called "small-cap" firms. A company's market capitalization is the market value of its outstanding shares - its stock price multiplied by the number of shares outstanding. These firms, whose market capitalization is under $500 million dollars, are most sensitive to whether or not adequate dollar liquidity is being supplied.
The leading index of small cap stocks is the Russell 2000, which is made up of 2,000 companies whose median market capitalization, as of a week ago was $383 million.
In a deflation, these firms are known to suffer the most as they, in effect, starve from the lack of capital invested in their firms or the lack of working capital borrowed from banks - a situation created by an insufficient supply of currency and bank reserves to the financial system and marketplace. It is these firms who feel the "liquidity squeeze" as their companies, when compared with mid-cap and large cap firms are the last to receive investment from institutions and individuals, as well as bank loans as the marketplace, in general, has a real and subconscious bias toward more making investments in Blue-chip and S&P firms with higher market capitalization.
Not surprisingly, the S&P 500 companies represent 75% of the entire capitalization in the stock market while the Russell 2000 firms and an additional 2,500 companies represent only 15% of the entire market capitalization.
And so, as a general rule, many watch the Russell 2000 index to get a read on how small-cap firms fare in the market place, especially during times of a deflation.
The publicly-traded Black owned firms are even more adversely affected by a deflation or insufficient dollar liquidity in that, on average, they are even smaller than the Russell 2000 firms, with some Black-owned stocks having a market capitalization of as little as $6 million dollars.
When insufficient liquidity is supplied, Black-owned firms are in the worst of all firms as they are the smallest of the small caps, often referred to as "micro-caps".These micro-cap stocks are seen as the riskiest of investments, the last in line for the available supply of liquidity and unfortunately, at times, discriminated against on the basis of color.
These firms benefit the most when capital is plentiful and that is why it is of paramount importance to Black publicly-traded firms that the Federal Reserve manage dollar liquidity appropriately.
This brings us back to the importance of the price of gold as a signal.
Because the Federal Reserve has a monopoly on the creation of currency and bank reserves referred to as the monetary base, it has the ultimate power to determine the price of gold.
This is because the actual demand for gold specie is relatively stable and the supply of gold is fixed - man can't alter it.
These two factors ensure that the physical demand for gold, at any moment, pales in comparison to the sea of dollar liquidity.
It is the supply and demand for dollars that is the chief determinant of the price of gold and not the mining firms, defense companies and jewelers who actually trade in the precious metal for business and manufacturing purposes.
Year after year this stable demand and supply for gold specie, as well as a few other qualities, make it the most monetary of all commodities and therefore the best indicator of whether the dollar is deflating or inflating or whether an insufficient or excessive amount of dollars are being supplied by the Federal Reserve to meet dollar demand. The price of gold can only change when the supply and demand for dollars has changed relative to the stock (or inventory) of gold.
For much of the last four years we have been undergoing a dollar deflation as the price of gold has dramatically fallen from $416 per ounce in January of 1996 to $256 per ounce in September of 1999.
This downward trend in the price of gold indicates that an insufficient amount of dollars was being supplied juxtaposed to their demand as the optimal price of gold, in the view of many, during this time period, where an equilibrium could be reached, was around $350 per ounce.
For companies in the stock market, particularly small and micro-size stocks, this time-period reflected a great amount of stress, as these firms could not obtain the liquidity they desired to maintain and grow their enterprises.
And sure enough it was the Russell 2000 index that was outperformed by the primarily mid and large cap NASDAQ and the primarily large cap Dow Jones Industrials.
But in September 1999 the downward trend in the price of gold broke, signaling relief for those small and micro-cap companies that had been starving for liquidity and carrying a tremendous debt burden as they were forced to repay all of the loans that they made in the time period from 1996 to 1999 with more valuable dollars, in terms of gold, than the ones that they borrowed.
And from September of 1999 until March of 2000 the price of gold moved away from its deflationary lows - reaching a high of $326 per ounce in October of 1999 and a high of $312 per ounce in February of 2000. Unfortunately by March 3, 2000 gold was back down, trading at $276 per ounce.
Interestingly, during this same time period Black stock after Black stock shot up in this new environment: Broadway Financial Corp (BYFC); Ault Inc. (AULT); Carver Bancorp (CNY); DME Interactive Holdings (DGMF); Granite Broadcasting (GBTVK); OAO Technology Solutions (OAOT); Radio One Inc. (ROIA); all broke out of trading lows beginning in September or October when the price of gold shot up and maintained higher levels in their stock prices until they headed downward in March and April in a trajectory that mirrored that of the movement in the price of gold.
ROIA is particularly striking in its correspondence with the price of gold. The stock takes off in September of 1999 precisely with the dollar/gold price, it heads back down in March, after the Federal Reserve failed to supply enough liquidity to maintain the highs that the price of gold had reached in the September 1999 to Feb. 2000 period. ROIA's stock then heads back up in June and July with the price of gold, and then, after a non-gold related fall in its stock, moves downward with gold, once more, in September of 2000 and continues downward through the new year as the price of gold hovers above $260 per ounce.
It is interesting to point out that because ROIA has a relatively high debt structure it was especially in a dangerous position during the deflation - consistently faced with the prospects of paying off its debt in a time period where the dollars it would return to its creditors would be worth significantly more than the dollars it borrowed.
By October of 2000 most of the Black stocks had begun to swing downward in harmony with the price of gold again and have either maintained a gradual downward trajectory or have been unable to break out of their lowest trading levels in the past 6-12 months.
And not surprisingly, since 1999, the Black stocks have almost unanimously performed worse than the Russell 2000 Index.
To compound matters for the Black stocks, the Federal Reserve is using interest rates to manage the US economy.
This method may help a few stocks on the higher end of the market capitalization scale and firms in the interest-rate sensitive sectors like housing, timber and financial services firms but it will do nothing to alleviate the liquidity problems facing small and micro-cap firms like the Black publicly-traded firms.
And thus far it has done nothing to lift the Black stocks out of their deflationary woes.
When the Fed lowered its federal funds rate last week, many market watchers anticipated that the rate cut of one-half-percentage-point might be enough to bring the stock market out of its doldrums. They were wrong as the rate cut announcement lifted many stocks on the initial news but had no sustaining power. Within days, stock after stock receded from price levels they achieved on January 3 - the day the rate cut was announced.
But more importantly, the decision to cut the federal funds rate had no effect on the price of gold, which, with a significant rise in price would have indicated that liquidity had returned to the markets.
In a portion of an especially insightful client advisory, Polyconomics Inc. international economist, Michael Darda, explains why lowering the fed funds rate will not work as advertised in lifting the stock market.
"The demand for 'funds' between Federal Reserve Banks (FRBs) is not the same thing as the 'market's' total demand for dollar liquidity. The former is determined by the FRBs that bid for reserves at the end of each business day in order to close their books on target. The bidding activity causes the Fed to buy or sell bonds -- add or subtract liquidity -- in order to keep its fed funds target in place. The latter, of course, is illustrated by the dollar/gold price, the most monetary price in the galaxy of dollar prices. Under its current operating paradigm, the Fed is targeting the price of credit, the fed funds rate, not the price of money, its purchasing power relative to gold."
Mr. Darda makes clear that targeting credit is not the same as targeting money. Targeting credit via interest rates is an indirect way of attempting to address the market's liquidity problem while targeting money is a direct way of addressing the same.
Larry Kudlow, a contributing editor at CNBC and economist at ING Barings, in a recent CNBC opinion editorial, described how directly targeting money would work:
"...fed funds rate declines do not by themselves insure an adequate volume of liquidity necessary to fund economic activity. Monetary base growth requires the stepped-up purchase of Treasury securities by the Fed. If gold prices and bond rates start shooting up, then the Fed has over-liquified. Should gold prices and bond rates continue to fall, then the Fed remains too tight. Just as a guess, monetary base growth should probably accelerate to 5% or 6%. But the central bank will know the proper volume of high-powered money in relation to economic demands for that money by watching inflation-sensitive market prices."
Kudlow is advocating that instead of the Fed relying solely upon the federal funds rate which really only impacts the supply and demand for money among member banks, the Fed should buy Treasury bonds directly from banks. This would provide the banks with additional cash reserves that could be leant or invested directly in the financial markets.
Kudlow advocates that the price of gold be watched as a signal as to whether too much or too little liquidity has been injected into the system.
While he can't be sure of the actual amount of liquidity that the system requires to reach equilibrium, Kudlow "guesses" that a 5 to 6% increase in the monetary base should accomplish the goal of providing sufficient liquidity to lift the markets.
Others agree with the form of liquidity management suggested by Kudlow, but don't think the Fed should actually concern itself with targeting a percentage of growth in the monetary base.
Mr. Darda actually recommends a clear target in the price of gold. He believes that Alan Greenspan should purchase bonds from banks until the price of gold reaches $300 per ounce.
"If he (Greenspan) could do that, financial markets would stage an extended relief rally, celebrating the end of Greenspan's deflationary squeeze on liquidity. Unfortunately, Greenspan seems to have forgotten about gold's ability to foreshadow price-level changes...", Mr. Darda wrote in a recent featured opinion-editorial for National Review magazine.
Others add that Greenspan's current management of the economy via interest rates will be of no help to smaller cap stocks and believe that Greenspan's deflationary disposition has created a negative market sentiment that can only be overcome by liquidity injections which budge the price of gold out of its most recent deflationary range.
Stephen Shipman, Portfolio Manager and Director Of Research at George D. Bjurman & Associates says:
"Market sentiment changed after the gold price couldn't sustain its upward Sept. 1999 to March 2000 trek. In the fourth quarter of 2000, the market realized that we were not returning to the gold price levels of above $300. It also realized that Greenspan wasn't going back to nirvana, so to speak, in terms of the optimum price of gold, and therefore the marketplace was going to have to accept a new ceiling on the gold price at around $275 per ounce."
Mr. Shipman says that because that sentiment has crept into the market he believes that a de facto price range of in between $250 and $275 per ounce of gold is in effect. He believes that the attractiveness of the Black-owned stocks in the eyes of investors depends greatly upon whether or not gold can break out of this newly established price range.
"Small-cap and risky stocks like the Black publicly-traded firms won't be increasing in value for any significant period of time until gold rises above $275 and stays north of that price level for a while. But if gold falls below $250, deflation becomes a major problem again", Mr. Shipman added.
"I cannot stress enough how important the gold price is for the Black-owned stocks. Greenspan's deflationary monetary policy has choked off the marginal investor in Black stocks. Greenspan's management of the economy via interest rates has withdrawn liquidity from the market; liquidity that I am certain was headed for these companies. And we know this because we can tell by how the decline in the price of gold corresponds with the downward movement in most of these stocks. The gold price is so important because it informs us of the durability of any liquidity changes impacting the marketplace."
Mr. Shipman also stresses the superiority of targeting the price of gold over the use of interest rates to steer liquidity into the market place.
"I correlate the price action of equities with the price action of gold. It is gold, not the Fed Funds rate, that signals the marketplace about the real effect of Federal Reserve behavior rather than their (Federal Reserve) spoken rhetoric. Greenspan and the Federal Reserve can say whatever they want. They can announce whatever interest rate decision they want, but it is the price of gold that signals what Greenspan and the Fed are actually doing - whether or not they are actually increasing or decreasing liquidity and how durable those liquidity changes will be."
Mr. Shipman adds that the durability of a liquidity increase or decrease is important because the marginal investor for a Black-owned firm tends to be an institutional investor who usually favors mid to large cap firms. When liquidity is taken out of the market place by mismanagement of monetary policy by the Federal Reserve, it is these institutional investors who pull back or decide not to invest in micro and small cap firms.
If the US economy is heading toward a recession as some believe, the Black-owned stocks had better become acquainted with the best friend that they may have never know about- the price of gold.
An appeal to the Federal Reserve to target the price of gold and to increase liquidity by purchasing Treasury bonds from banks until the price of gold reaches $300 an ounce, should be a top priority of Black business and political leaders.
The best hopes for a long-term increase in the value of every Black-owned stock may depend upon it.
Tuesday, January 9, 2001