Tuesday, September 2, 2008

Asset Class Analysis - Gold & Precious Metals

Gold: What Have You Done For Me Lately?

Much debate has recently swirled around the non-mainstream internet media about the future of the precious metals markets. Differences in opinion usually stem from disagreements on the directions of inflationary pressures and/or credit risk. This entry is devoted to distinguishing between the various view-points and to arrive at a thesis for the intermediate and long term directions of the precious metals.

What is Gold?

The mainstream view on the utility of gold is as a price inflation hedge. However, a proper definition of inflation is required. I use the Austrian definition of “an expansion of money and credit.” So, gold declining through the 80’s and 90’s while inflation was positive would prove to dispute the consensus. A better argument can be made for gold as most valuable during times of hyperinflation or deflation. Some view gold to be money, some as a commodity. It has both characteristics.


The price of gold, denominated in dollars, was historically fixed at approximately $20/oz (1833-1931). During the Great Depression most western countries left the gold standard so they could dilute the money supply and pay for economic mega projects like the New Deal, and later, WWII. In some cases (ex. The USA), gold was confiscated from the public. It traded at approximately $35 until 1971 when the gold window was closed and dollars were no longer convertible to gold. Gold proceeded to nominally increase twenty-fold over the next nine years. The reasons for this were dramatic increases in the money supply and increasing indebtedness of major nations - again commonly to pay for foreign wars. This resulted in spiralling higher prices and, perhaps more importantly, higher expectations for future inflation. Much of those future expectations turned out to be unjustified as the dollar lost ‘only’ approximately half of its value during the 70‘s (according to government collected price data). The Volcker Fed raised interest rates to 18% leading to a 20 year period of decelerating inflation (disinflation) and a collapse in the gold price.

On an average yearly price basis, adjusted for inflation, gold lost approximately 80% of it’s value over those 20 years and bottomed in 2001 around $250/oz. It began a new secular bull market on the back of the collapse of the tech bubble and massive credit creation by the Greenspan Fed. The subsequent rise in public debt and perceived credit risk has helped the gold price stabilize at a historically high nominal value, demonstrating price acceptance (unlike in the previous bull market that only saw one year of average prices above $400).


Spending vast amounts of time sucking up information as I do, I have come across quite the array of differing opinions on the precious metals markets. Although I have noticed there are 3 primary camps in which those people fall.

The first (and most numerous) are the “Cinderella Crowd”, confidently proclaiming the economy to be safe and sound and that nothing but good times are ahead. They usually view gold as a barbaric relic of the past, with no actual value. I don’t spend much time listening to these folks. They’ve been wrong at every major turn for the last 3 years and the quality of their analysis seriously lacks credibility. These are the Ben Steins and Larry Kudlows of the world. They are shills for the status-quo, for neo-conservatism, and for Keynesian Economics. Unfortunately, if I were a new investor, these are the guys that would pop up first on any internet search or on TV.

If you were to dig a little deeper, you may find some very smart folks who have been talking about some of the problems facing our economies for many years. Guys like Peter Schiff, Doug Casey, and Jim Puplava were talking about the housing bubble long before it peaked. They forecasted the economic slowdown we are now experiencing back in 2005 (or earlier) and correctly predicted much higher commodity prices far before it was ‘cool’ to do so. They have correctly pointed out that the Federal Reserve will try to do anything to prevent this crisis from escalating and therefore will attempt to create immense amounts of inflation in doing so. The result, according to this camp, will be a 70’s rerun of Stagflation that will eventually evolve into a Weimar-style hyperinflation. Gold will be a great investment in this environment, and has an infinite potential for price appreciation.

Another, far smaller, crowd has been arguing the same problems facing us, yet see a different outcome. Analysts like Mike Shedlock, Steve Saville and Kevin Depew feel that the Federal Reserve is not as mighty as the previous group believes, and that they will ultimately fail in their inflation campaigns. This group has been calling for a severe repricing of risk and assets leading to the opposite outcome - deflation. In their opinion, gold will return to it’s historical utility as a safe haven and as a “no default asset”. The price of gold may rise depending on many factors, but chances are it will nominally outperform other asset classes in this situation.

The Facts

There are four primary factors that one should understand thoroughly before investing in any specific asset class. Structural, Psychological, Technical and Fundamental. By ignoring any of these potential catalysts the investor is flipping a coin.


As we have witnessed over the last year, the US economy (and the world economy by extension) is on uneasy footing. Enormous government deficits, growing income disparities, rising costs of food and energy, falling asset prices, rising unemployment and slowing consumption trends are just a few of the problems facing us. This is all happening when the driver for our economy, the “baby boomers” are planning their retirement and becoming less productive. There is a sense of scramble in the eyes of the boomers, as much of their wealth was tied up in their homes. Their plan was to sell the home when they retire and live on the proceeds combined with whatever meagre pension they have accumulated. The problem with this finely crafted plan should be self-evident, but apparently was not. In order to sell your house, somebody needs to be willing and able to buy it.

With credit conditions deteriorating weekly, banks are becoming less and less willing to lend. And with home prices falling so dramatically, younger generations no longer have the urgency to move up or make their first purchase. This is having further downward pressure on home prices (and commercial real estate) as supply mounts from completed construction and foreclosed homes. Just recently, the supply of unsold homes reached a record high level, suggesting that prices are likely to continue lower until the supply/demand curve is tilted the other way (or until it is perceived to do so in the near future).

Most people would agree that the health of the housing market and the profitability of banks are closely intertwined. Many of the loans banks have made are real estate oriented. This is not a problem if banks only lent out as much as they had in deposits being held. However, banks and mortgage brokers typically lend out more than 10x the amount they take in. So if their loan portfolio drops by more than 10%, they are technically insolvent. In order to hide this inconvenience, banks have resorted to storing their problem assets on opaque off-balance sheet vehicles and have resisted acknowledging their depreciating values. The Federal Reserve has also made it easier for them to temporarily exchange their troubled assets for safer Treasuries. Credit spreads have been widening constantly, meaning the cost of borrowing money is rising for banks and other leveraged businesses. This is a recipe for mass failures of large and small banks and many other credit dependant businesses.

Such potential financial turmoil is a bullish development for gold, should it unfold the way I think it will. But such a deflationary banking crisis may not see the price of gold rise as much as it simply stays stable while prices of most other assets fall.


The consensus on Wall Street is that most of the major problems are behind us and that financial companies will lead a huge rally in the equities markets in Q3 and Q4 2008 on the back of astronomically higher earnings. Looking at the credit markets, I fail to see how this is possible. The same analysts’ consensus for Q2 was off by an enormous 30%. So it is possible that “the worst is behind us” mentality is already priced in, leaving much upside potential.

However, it is important to understand that gold (and other commodities) have experienced massive price increases already since 2001. It has been a decade where profits for investors are few and far between, meaning some investors may take the opportunity to experience profits and sell their gold exposure. Central banks that hold large reserves are susceptible to such thinking as well.

On the other hand, there is a very prominent feeling on Wall Street that groups gold with all the other commodities and labels them a “bubble”. The price patterns of crude oil can be compared with other stock bubbles like the Nikkei of the 80’s or the Nasdaq of the 90’s and a convincing argument can be made that it is a bubble. A subsequent decline of 20% in the price of oil had many calling for a burst of the bubble and a “new bear market in commodities.” While this may be true, we should note that crude oil regularly has corrections of 20%, as does gold. Additionally, the supply/demand characteristics of oil has not been consistent with the bubble label.

So, while the overwhelming sentiment toward gold is currently bearish, not much should be read into that observation. With disappointments pending on financial earnings projections, gold’s value could decouple from that of other commodities and the Euro and start acting more like money and less like a commodity.


The failure of gold to make new highs in June/July and it’s subsequent correction of 25% from the March highs suggest that gold may be in for some continued downward pressure towards key moving averages and retracement levels.

As can be seen from the chart above, there is a confluence of technical support levels between $670 and $735. Gold has broken it’s 50wk EMA decisively for the first time since the bull began in 2001, suggesting that a lower level will now become support. It is possible that gold has just made a “V” bottom and will quickly revisit the highs, however the advance of the last two weeks has been on low volume and may not be significant.

The most likely outcome, in my opinion, is a long period of sideways price movement between $650 and $900. This would enable the longer term moving averages to catch up and will provide a solid base for the precious metals to advance in the autumn of 2009.

The work of Tim Wood, bi-monthly wrap-up contributor at Financial Sense, would agree with this analysis. Tim has studied cyclical moves in the price of gold and has identified a fairly prevalent 9 year cycle. It is possible to see a year or more of sideways to negative price movement before seeing the resumption of a “Super Cycle” move higher lasting toward the end of the next decade.


Although there has been a shortage in the availability of small denomination gold and silver coins, there is no shortage of the metal itself. To test this, one can simply buy a futures contract and take delivery. The likely cause of this disconnect is increased buying from small investors and increased selling from hedge funds who owned futures contracts.

As I mentioned earlier, many investors buy gold to hedge against heightened expectations of future inflation. Although inflation readings (as measured by the BLS in CPI and PPI releases) have been very high of late, this is a rear-view mirror perspective. Inflation expectations (as measured by the differential between the 10 year US Treasury and 10 year TIP) are at 5 year lows (see: http://www.northerntrust.com/popups/popup_noprint.html?http://web-xp2a-pws.ntrs.com/content//media/attachment/data/econ_research/0808/document/dd082008.pdf), signalling bond traders fear lower price movements, not higher. This would make sense with slowing consumer spending and contracting credit conditions.

Another factor affecting the price of gold, and one I mentioned earlier, is it’s perceived role as nothing more than a hedge against the US Dollar. Over the long term, it serves as common sense that the value of one thing relatively static in supply will rise in relation to something that generally increases in supply. However, this has not always been the case, as the demand for gold as an asset rises and falls for other reasons than as a dollar hedge. Financial distress in Europe could see greater demand for gold in Europe and a weaker Euro. This happened in 2005 where the Euro fell by ~15% to the dollar and gold rose ~20%. As I write this on Sept 2, the day’s trading is evidence of this possible shift in perception. The Euro has made a new 7 month low and closed weak, while the price of gold opened above it’s August low and rallied strongly as the day progressed.


I hate making conclusions as to price direction of any assets, because I believe it is impossible to do so. Chaos theory ensures that even one small unexpected event from across the world can have important directional implications for all markets. However, we are able to determine the highest probability outcomes based on historical behavioural patterns. Therefore, I prefer to label my analysis as a working thesis, always adaptable to external changes.

With that in mind and with the above factors taken into account, I believe the most likely outcome for the precious metals markets is to be for a fairly prolonged period of stagnant prices. This period would likely be accompanied by relative underperformance of other asset classes due to the financial problems that will persist in the global economy. This process has been underway for the last 6 months (dating from the March 08 high) and may persist for as long as another 12 months. After such a period, the technical and psychological components to the precious metals markets will be more amenable to another multi-year period of rapidly rising prices.

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