The cycles of speculation

It may be stated without hesitation that the effect of the increasing supply of gold upon prices of all bonds, shares, or commodities which may be classed as speculative, is more decided and certain in its operation than any other single factor. The process of readjustment due to this cause would be slow and regular if the principles at issue were universally and clearly understood. Not being generally recognized, however, the changes wrought by what is naturally an insidious factor are, at times, spasmodic and feverish. It is a remarkable fact that whenever a revolution occurs in any economic or financial process which is, by its nature, concealed or recondite, its existence and influence are discovered by a number of students simultaneously but independently. Important reversions or modifications may be submerged for a long period, and suddenly light is offered from all parts of the thinking world. It is probable that this intellectual phenomenon extends to, or is communicated to the financial world, and that marked and drastic changes in the affected quarters represent a belated recognition of forces hitherto unknown, and the readjustment of affairs by those who see first and furthest. That the operations of this minority will be important goes without saying. The faculty to grasp fully and quickly anything salient bearing on financial affairs is the ground-work of riches and consequently the trained minds of great holders of shares or commodities will respond most readily to sound basic arguments, and the greatest holders can often make of their knowledge a two-edged sword. For example, certain large holders of bonds, recognizing the fact that increasing gold production means higher interest rates, and consequently lower prices for bonds, would be able to dispose of bonds to advantage because of the apparent general prosperity growing out of this same production of gold. It may be assumed that in pointing out in interviews, etc., this reign of prosperity, the gentlemen in question would modestly omit to mention that the same influences which were causing high prices and much business in some quarters, were working damage in others.

Something of this kind has been going on in our bond and stock markets of late. The inevitable influence of gold on prices has made itself slowly felt for a long period, but it is only in the last year that a considerable number of individuals whose operations are of importance in the financial world have come to recognize how powerful this influence is. Price changes in divers securities and commodities hitherto unaccounted for, or attributed to wrong influences, have suddenly been explained to a number of important financiers, and a correct understanding of the problem has undoubtedly resulted in radical readjustments in some quarters. With that pertinacity in error which seems to distinguish the ordinary speculator, he has, however, gone on attributing these processes of equilibration to causes which have only a limited bearing on the case. The recent heavy decline in bonds and stocks, for example, was popularly ascribed to political and legislative action against railroads. Scarcity of money was given second place in these deductions, and gold production third place, or no place at all. If we reverse this order of importance and give gold production first place, monetary affairs second place, and political affairs third place, we are nearer the truth. It looks a little ridiculous that the scope of intelligent perspective should be blocked by three thousand miles of water, and that the unthinking majority who ascribe our decline in bonds to local politics should have failed to recognize so potent a fact as that the decline was world-wide; but such is the case. The readjustment in bonds was due to excessive over-production of gold, and it may be safely assumed that so long as this over-production continues to increase rapidly, bonds will continue low in price or, what amounts to the same thing, interest rates will remain high.

As to the importance of a correct understanding on this subject of gold supply and its influence on prices, I quote from Mr. Byron W. Holt’s book “The Gold Supply and Prosperity,” which, I may add, is used as the text book for this chapter. Mr. Holt says:

“This is the great problem that now confronts the financial world and demands solution of every investor. Not to solve it may mean great loss and possible failure. To solve it means success and greatly enhanced wealth for all who now have either a fair share of this world’s goods or who have credit and can intelligently go in debt for a large amount.”

As speculation or investment-speculation, as defined in the introduction to this book, are the subjects under discussion it is the intention to take up, in turn, such points as bear particularly upon price changes of speculative shares and commodities influenced by our increasing supply of gold. The main points to be considered are as follows:

• 1—The effect upon bonds and preferred stocks having a fixed
• rate of income.
• 2—The effect upon common stocks of railroad corporations.
• 3—The effect upon stocks of industrial corporations.
• 4—The effect upon speculative commodities—wheat, corn,
• oats, cotton, etc.

For the purpose of argument it will be assumed in this discussion that our supply of gold is rapidly increasing. We know that such has been the case in recent years, and it is the opinion of most students that this increase may be confidently expected to continue. To quote again from the work already mentioned:

“Both the output and supply of gold are likely to increase for many years.

“While the future output of gold is, of necessity, unknown and uncertain, there is great unanimity of opinion, among mining experts, on this point. It appears to be generally recognized that, during the last twenty years, the industry of gold mining, or rather of gold production, has been established on a very different and much more certain basis than any previously existing. No longer is the output of gold dependent mainly, or even largely, upon placer mining and the chance finds of ‘free’ gold. The supply of gold, in rock, sand, clay, and water, being inexhaustible, it is now possible, by machinery and metallurgical processes, to extract gold, in paying quantities, from many forms of these vast store-houses. To such an extent is this true that the future supply of gold is even more secure than is that of coal, iron, lumber, wheat or cotton.

“Even if prospecting were to stop and attention were to be devoted only to the gold mines and bodies already discovered, and geologically in sight, it is probable that the output of gold would continue to increase for many years. As Mr. Selwyn-Brown, a gold mining expert, tells us in his very interesting article, ‘as the rich surface deposits are being worked out, improvements in mining and metallurgical processes are enabling poorer and poorer deposits to be worked.’ That is, improvements in ‘stamp mills,’ cyanide mills, dredging machines and other gold extracting apparatus and processes are being made so rapidly that it is, every year, becoming profitable to work lower and lower grades of ore, sand and earth. As the grade declines the quantity in sight increases rapidly. In fact there are almost literally mountains of low grade gold ore that can even now be worked profitably. Some of the largest, most productive and most profitable mines of today contain ore averaging less than $3 and, in some instances, only $2 of gold per ton.

“The supply of such ore being inexhaustible the output depends upon the number and size of the mills employed to extract the gold. It is reasonably certain that, for years to come, the improvements in methods and processes of mining will more than keep pace with both the decline in the quality of the ore and the increase in the cost of mining due to rising prices and wages, occasioned by the depreciation of gold.

“In view of all the facts, Mr. Selwyn-Brown’s conclusion that ‘a progressive increase each year may confidently be expected’ is conservative. This conclusion, is almost a certainty. The uncertainty lies in the possibility, if not probability, either of discovering many important new mines in the practically unexplored parts of every continent, or of making improvements that will radically reduce the cost of extracting gold. In either case the increase in the output of gold might be not simply arithmetically but geometrically progressive.”

Admitting that the question of gold production is debatable, it remains for the future to develop any radical change, and it will be necessary for the student to decide this point for himself either by the light of facts as yet not established, or by accepting theories as yet not convincingly erected. If a change occurs, or may reasonably be expected, an understanding of the subject from the positive side of the question loses none of its value. The principles involved could be as successfully applied in reading the probable future by modifying or reversing effects, and reconciling them to a modification or reversal in the cause. If, for example, we accept the theory that increased gold production means advancing commodity prices, and find reason later to believe that gold production will cease to maintain its ratio of increase, we may alter our views accordingly so far as this single influence is concerned.

1—The effect of the increasing gold production on bonds
and preferred stocks having a fixed rate of income.

In this division of the question the crux of the whole matter is interest on money. The question might, in fact, be stated thus: “What is the effect of increasing gold supply on money interest rates?” and having solved that problem, the original inquiry is answered.

To reach a reasonable solution we must first examine the effect of an unduly increasing supply of gold on commodity prices. Over-production in any quarter inevitably leads to lower prices. Gold being a fixed standard cannot decline in figures, but it does so in fact. That is to say, the flexible prices of things which gold will buy rise to fill the gap. Thus, since 1896, prices of commodities have risen 50%. The man who loaned money ten years ago finds its purchasing power impaired 33⅓%, when it is returned to him today, for the reason that commodity prices having advanced 50% in the interim, his dollar will now buy only 66⅔% of what it would buy in 1897. This impairment of principal will be covered, in part at least, by interest rates. This effect, if not recognized and arbitrary would adjust itself automatically, regardless of whether or not investors recognize the influence of changing values of gold, for money, finding higher returns in other quarters, would speedily desert the long-term, fixed-interest investment field, and prices of such securities would decline through lack of demand.

On the subject of interest rates Mr. Holt says:

“But there is another reason why interest rates should be high when prices are rising. When money is shrinking in value interest rates should be high to make up, or partly make up, the losses on the principals of loans. To illustrate: Suppose that prices are rising 10% a year. This means that the purchasing power of money is declining about 10% a year. Suppose, then, that $100 were loaned for one year at 5%. At the end of the year the lender would have $105; but with this $105 he could buy only about as much as he could have bought with $95, at the beginning of the year. In reality, he has received no interest at all but has, instead, paid $5 to the man for holding his $100. The man with money to loan cannot afford to do business in this way. He is usually as wise as are his neighbors, and fully as able to protect his own interests and to get all his money is worth, either by buying real property, investing in bonds and stock or by loaning on notes or on call.”

In submitting the above contentions it must be fairly stated that there is some diversity of opinion as to the effects of gold on interest rates. A few writers demur to the theory; others hold that the effect is nil, and one or two openly adopt the negative side of the discussion, and state that more money means lower rates of interest. The majority of recent investigators, however, appear to be accepting the theory as given herein, and it may be added that prices of the class of securities considered have borne out the hypothesis faithfully, and that the minority have failed to offer convincing explanations of this readjustment. It will not do to point to the fact that money has been fully employed in constructive rather than investment fields of late; for while this is true enough, it does not explain why gilt-edged bonds such as British Consols have declined in value, while stocks and shares which did not bear the onus of circumscribed returns have advanced. There are, of course, contributory causes: the Labor-Socialistic Government in England no doubt affects the prices of consols, but this influence is specific, and loses most of its force when we consider that not only these particular securities, but practically all others of their class the world over have suffered a radical decline. In other words, interest rates have grown comprehensively higher. The theory appears sound, is borne out by events, and mere denial does not weaken it. It may well be accepted until its opponents succeed in giving us something more convincing in its place.

In support of the theory, Mr. Holt reproduces the following table of British bonds from Moody’s Magazine for October, 1906.

PRICES OF BRITISH INVESTMENT BONDS.

“Thus,” comments the writer, “these 13 British bonds, supposedly the safest and least speculative of all securities, have declined an average of over 28 points in ten years. Considering incomes and present prices, the unfortunate investors in these bonds have not only received less than 1% on their investments, during the last ten years, but, should they sell their bonds, they would find that the proceeds have lost 30% of the purchasing power of a similar amount ten years ago. Altogether, they have suffered a net loss, over incomes, of more than 20%, or over 2% a year.”

There are other economic influences affecting interest rates through gold supply, but the one given appears to the writer the most direct and forcible when applied to readjustment of prices to income.

In weighing the influence of increasing gold production and its effect upon interest rates through the advancing prices of commodities, the student is liable to fall into one grave error. He may perhaps jump to the conclusion that gradually advancing prices of commodities mean gradually advancing rates of interest. This is not at all the case. A sustained ratio of advance means sustained high rates of interest—nothing more. In order to make this clear let us go back to the original principle.

Increasing prices for commodities mean an impairment of the purchasing power of money. If the purchasing power of money is impaired 2% per annum through increasing prices of commodities, and the normal rate of interest is 4%, we can cover the deficiency by making the interest rate 6% and leaving it there as long as this ratio of impairment is maintained. In other words the man who loans $1,000 at 6% loses $20.00 per annum in the impairment of capital and receives normal interest of $40.00 per annum and $20 extra to cover his loss in capital. Strictly speaking the extra 2% is not interest at all, but an amortization payment. It matters not how high prices ultimately go, he receives each year a bonus sufficient to cover his loss in capital, and the interest rate remains 6%.

Therefore, if prices of commodities advanced for ten years and then ceased to advance, but were maintained at the highest figures reached, interest rates would fall because there would be no further impairment of capital, and what was formerly amortization, would become usury. On the other hand, if a new ratio of increase should occur in commodity prices and they should advance 4% per annum, interest rates would, if fully adjusted, reach 8%-4% for normal interest, and 4% for impairment of capital.

2—The effect upon Common Stocks
of Railroad Corporations.

Here the effect of high interest rates is, or in time may be, offset by returns in the form of dividends, undivided profits, improvement of property, or the fact that income is not limited. But there is another trouble, and a serious one, for which the gold supply is responsible.

If the increasing supply of gold is responsible for higher commodity prices it must be at once apparent that the building, equipment and maintenance of railway properties costs more and more as all commodities, including labor, advance in price. This would be all right if the selling commodity, i. e.: transportation, also advanced proportionately in price; but it is so difficult to override popular prejudice and widespread misunderstanding on this point, that we find continued agitation and legislation not only against advancing rates, but with a view to reducing those which already obtain. There must, of course, be a limit to this thing, and if the cost of production continues to increase, the railroads must be permitted to demand higher prices for transportation. Otherwise a point would finally be reached where every railroad in the country would be forced into bankruptcy. The great danger lies in a belated assimilation of this truth by the masses, and too much demagoguery on the part of politicians who do understand, but, being politicians, prefer to reflect the views of a majority of constituents, rather than to enter a campaign of proselyting. That evils have been fostered and wrongs committed by eminent railroad financiers is certain; but there is considerable confusion of ideas on this head. Over-capitalization, illegal combinations, manipulation of funds for private gain, and the swelling of dividends for stock-jobbing purposes, when the funds so distributed should have gone into improvements or surplus, have all played their part in arousing the wrath and indignation of the great majority, and they are, as a class, prone to jump to the conclusion that any and every railroad corporation is charging unduly high rates for its services, and making exorbitant returns on invested capital. This has, no doubt, been more or less true in the past in certain cases where extremely high rates were made, and the apparent returns on money attenuated by over-capitalization; but this evil is gradually decreasing, and the real fight is, or should be, against these abuses. The railroads are suffering for the sins of the past, and may suffer still further; but the time is not far distant when, unless conditions change radically, the railroads must be allowed more latitude in the adjustment of rates.

The prevalent opinion, that needed reforms which strike at the root of the evils mentioned above is a bear argument, is another popular fallacy. Such reforms intelligently conceived, and unswervingly carried out, are all in favor of the small shareholder. If laws can be enacted which will prevent individual interests from plundering or misusing the funds of corporations, and which will compel these corporations to issue reports and statements which are not so involved and complex as to be beyond the ordinary comprehension, the small holder or investor will have a better show. But, having cured these evils, no laws can possibly endure which contemplate curtailing fair returns on money, and fair profits through natural enhancement in values.

But, however fair or cheering this view may appear, the fact remains that it will be slow in its acceptance and slower in its operation. We may therefore summarize the situation thus. Increasing production of gold brings about increasing cost of operation, and so long as cost of operation is advanced with no corresponding advance in selling price of transportation, the ratio of profits will gradually decrease until a vanishing point is reached.

In the last analysis, a probable tardy and reluctant recognition of the true status of the case warrants the belief that for the near future, the railroads have a hard time ahead of them, and that so far as this single important influence is concerned, it is decidedly a bearish factor.

3—The effect upon stocks of
industrial corporations.

Here we have a different proposition. Rising prices for commodities do not interfere with the earning power of corporations which produce and sell commodities, the prices of which are not limited by law. In fact these corporations are, in many cases, gainers by this influence which tends to advance prices, not only of what they buy, but of what they sell. It may be added, parenthetically, that railroad companies which own valuable coal lands, etc., find the bad influences already discussed partially offset by the gain from such holdings. The railroad company, however, may be considered as pre-eminently a seller of transportation and has been so regarded herein.

The industrial corporations whose products are subject to regulation by law, such as gas and electric lighting companies, are subject to practically the same influences as those which operate against the prices of railroad stocks. Their cost of production advances easily and inevitably, and the selling price remains fixed, or advances with difficulty and under protest.

4—The effect on speculative commodities—
Wheat, Corn, Oats, Cotton, etc.

This phase of the subject will be dismissed with a few words. If the contentions already made are accepted, it is apparent that all such commodities will gradually seek a higher level. A brief examination of statistics will show that this readjustment has been going on for years. The gradually ascending pivotal point, or average price, is particularly marked in the cheaper cereals,—corn and oats, and also in cotton. This is probably due to the fact that wages have not advanced as rapidly as have prices of living. It is found that in periods of hard times consumption of cheaper foodstuffs and textile fabrics is increased, while the consumption of higher priced commodities and luxuries are curtailed. The wage-earner, therefore, has been in reality living in a regime of hard times, although this fact is easily submerged by steadier employment, by a fictitious appearance of general prosperity, and the ability to spend a larger number of dollars, without realizing fully the loss of purchasing power in the dollars.

It would be out of the question to attempt to enter anything like a comprehensive study of the question of gold production and its effects in a single chapter, or even in a single volume; neither is it necessary to the purposes of this work, for the student who desires a comprehensive education in this regard will find ample means and material ready to his hand. From the standpoint of investment and speculation alone, it is submitted that increasing production of gold is, to use the phraseology of the street, bearish on long time bonds and other securities yielding a limited rate of interest or income, temporarily bearish on railroad stocks, bullish on industrial shares, except as noted, and bullish on speculative commodities.

At the risk of indulging in undue reiteration, attention will again be called to the fallacy of considering such subjects as the one of gold production too remote in concrete effects, or too sluggish in operation to be of importance to the speculator. A thorough understanding of cause and effect bears upon the operations of today, in that it anticipates the results of tomorrow. Through knowledge of influences of this character, serious error may be avoided. For example, one of the profound axioms of the speculative world is that bonds advance first and stocks afterwards. If we understand why bonds have been, and are at present, declining we may be justified in modifying this view and considering the axiom more or less obsolete. He who operates an engine without a clear understanding of its motive power is likely to get into trouble, or perhaps be blown up.

It may be pointed out also, that a too literal acceptance of the suggested effects of this or any other great price influence is highly dangerous. Even while gold production continues to increase rapidly, prices, not only of shares, but of all things, will overleap themselves and will also swing backwards to the other extreme. The cycles are not completed, until both zenith and nadir have been touched. Changes in gold production will not prevent declines in prices; they will, however, interfere with the regularity of the cycles.

This chapter may be fittingly closed with the following list of conclusions reached by Mr. Holt, in the work already mentioned. These conclusions cover all the points herein presented, and others which are of interest and value:

“In view of all the facts, results and possible consequences connected with the increasing output and supply of gold, The Wall Street Journal was right when, on December 4, 1906, it said that ‘No other economic force is at present in operation in the world of more stupendous power than that of gold production.’”