Gold as a Truly Last Resort

January 12, 2009

It was, for many investors, confusing not to see gold surge to multiples of its current price. I mean, shouldn’t gold have dramatically surged in this financial tsunami? Most investors, including myself, forgot that gold was a playground to some deep pocket investors from the hedge fund industry that got hit tremendously by redemptions and massive forced deleveraging because of a domino collapse of prime brokers such as Lehman (LEHMQ.PK) or Bear Stearns. The result was a fire sale in COMEX gold futures and paper products with gold as underlying.

The physical market was different, particularly in the third and fourth quarter of 2008. Even though physical demand was very strong and supply reached its upper limits, the price of gold even declined. This was only a short lived market distortion triggered from the paper gold market. In the last couple of weeks, the market already rebalanced the price as gold went from sub $700/oz to roughly $900/oz. The pressure from forced sellers and fund liquidation sales is more or less over and this should pave the road for much higher gold prices in the future.

Another interesting realization was that gold can only move up when the financial system is not faced by a complete meltdown. Is gold truly a reliable hedge against an asset meltdown as it was in the past? Yes, but we have to differentiate. The very important lesson to learn was that gold can only perform if the system itself is not under massive default pressure; at least in the first phase. So is the run now over? It is far from over. Technically, gold is moving up again and the move will very soon be supported by a crash in the currency and particularly bond markets.

Gold: The Truly Last Resort

The pre last resorts in the current financial crisis were the bond markets (particularly the US treasury market) and the US dollar. I’ve explained in previous articles why the US dollar was going up and it also explains why it is going down now. Investors were desperately putting money into the bond market, not because they like bonds, but more because they wanted their money out of equities, commodities and derivatives. Since the US treasury market is the biggest bond market in the world, the huge appetite for US treasury was accompanied by huge appetite for buying the US dollar and selling other currencies in exchange. The bond market (particularly government bonds) is the biggest bubble today and once this bubble bursts then the only asset class that remains will be gold. At this point in time, gold will surge and investors will move huge amounts of money into physical gold and gold stocks because this is truly the last resort.

The Point of No Return: When Gold Will Explode in Value

Gold is the true last resort and this is also a reason why the price of gold has not exploded in the past couple of months. The financial system has not yet reached the stage of last resort but it finally will because the point of no return was passed. Governments and central banks around the globe decided to save the current financial system at all costs. Quantitative easing and aggressive fiscal stimulus will eventually create huge inflation and fundamental changes to our societies and economies. They can’t go back but only forward with faked statistics and money printing to keep the system alive as long as possible to hope for a solution. There is a solution, but it is very unlikely to happen, unfortunately.

Inflation is coming and it is coming back furiously. Quantitative easing accompanied by a zero interest rate policy and massive fiscal stimulus will eventually trigger a hyperinflation environment. Right now, we are in a deflationary market environment with virtually all asset classes losing value. The bond markets have been the only exemptions, but only because investors were putting money into the liquid bond market to park it. The same is true with the US dollar - we are not really in a US $ bull market that is driven by sound fundamentals. I believe that the leading global currencies will eventually crash because the fundamentals are worse than ever. Huge government deficits, huge retirement obligations, unpayable social security systems (in its current status), massive interest burdens on corporate and government debt and demographic changes leading to higher taxes and less income (baby boomer generation will retire and stress the current social security system to its limits). Government bonds particularly in the USA will implode and default in value.

Is it sure that the quantitative easing will trigger inflation? No, not theoretically, but practically. There is a pretty simple formula to explain the function between the amount of money and inflation. The theoretical concept I refer to is the so called: quantity equation: M x V = P x Y, while

V = Velocity of money (frequency with which a unit of money is spent)

P = Price level

Y = Real GDP

The amount of money (M) in the system has exploded and if the velocity of money (V) and real GDP (Y) remains stable then prices (P) must rise. Right now and very likely as always in deflationary environments the velocity of money is slowing (people are starting to save rather to spend) – real GDP is also shrinking. This mechanism allows that the amount of money can rise substantially and is therefore not necessarily triggering inflation. The problem is that once the cure (more money and aggressive fiscal spending) starts to work then the velocity of money is also picking up in speed. When this happens, the only method to avoid huge inflation will be to reduce the amount of money or hope for some spectacular GDP growth that is triggered by huge efficiency gains in the economy (but this is a dream right now).

So, inflation is theoretically not preassigned, but practically inevitable. The people put in charge to avoid a huge surge in inflation are the same as when this mess started: Fed, treasury, government, etc. They had no idea when this crisis began (they are even responsible that it happened!) and they have no idea when it will end and therefore they will never be able to take all this money out of the system and this will ultimately lead to inflation. That’s why I’m sure inflation will come back in the not so distant future.

Some people also mentioned the gold standard as a possible solution for a sounder monetary system: I don’t think that this is a solution. The gold standard would be far too restrictive and would prevent economic growth at the upper limit of balanced potential growth. But central banks would do well to change towards a more responsible monetary policy in remembering the gold standard.

Investment Strategy

I recommend investors to be short government bonds and long corporate bonds from leading, reliable and sound companies which are market leaders in their sector. Equities should also perform much better than bonds mainly because of the pending inflation shock. I recommend buying value stocks with low p/e ratios and a strong balance sheet. A core investment should be some heavily battered base metal related stocks such as BHP, Rio Tinto (RTP) or Freeport McMoRan (FCX) and energy/oil related stocks such as ExxonMobil (XOM), ConocoPhillips (COP) and Royal Dutch Shell (RDS.A).

The best investments for the long term will be real assets such as farmland and equities related to agriculture (fertilizer, machine manufacturer, etc.) and commodities. If a rising number of dollar bills are chasing a more or less stable number of real assets then these real assets will go up in price. Besides short government bonds and long corporate bonds and long commodity related equities a must own is physical gold or gold related equities such as Goldcorp (GG), Barrick Gold (ABX) or Newmont Mining (NM). Physical gold is a hedge against the coming financial Armageddon and belongs in every investor’s portfolio.

Disclosure: No positions. The opinions expressed in this article are those solely of the author and do not necessarily agree with the author’s employer.

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