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A Golden Role Reversal

September 16, 2009 by  

A Golden Role Reversal

Sometimes, things aren’t what they seem on the surface.

Case in point: Pundits have been making a lot of hay recently over gold’s apparent role-switch. Instead of rising on bad economic news and acting as a safe haven, the metal has been falling. And instead of falling when the economic picture brightens, it’s been rising.

Of course, gold’s fortunes are tied to the U.S. dollar, which remains (at least for now) the reigning king of fiat currencies. But the dollar has also apparently reversed roles.

So what’s going on here? Have gold bugs entered some sort of Bizarro world where down is up, up is down and they need to start hoping for a rip-roaring economy instead of a fiscal catastrophe?

Good News Is Golden

When you dig just beneath the surface of the recent headlines, data points and trend lines, you see that things aren’t quite as confusing or misplaced as some might imagine.

Bottom line: The investing world is currently divided between those who think another economic crisis lies ahead and those who feel that “happy days are here again”… or at least will be soon.

So, follow the logic: Negative economic data raises the specter of another economic nosedive toward deflation. In that scenario, investors are assuming the U.S. dollar would rise in value as the prices of everything else fall. The dollar would also function, as we saw at the depths of last year’s credit crisis, as a safe haven investment, and would accordingly benefit from this demand.

Of course, gold could also do well in a deflation. In the Great Depression, for example, gold and gold stocks were about the best investments you could make (if you had any money left), because gold was also the official U.S. currency at the beginning of the downturn. And later, when the gold standard was abandoned by FDR, that decision was accompanied by a dramatic devaluation of the dollar and upward valuation of gold.

But forget about this for now. Few investors today realize that gold can do well in a deflation, and the rest wouldn’t believe it if you told them. So this doesn’t currently factor into the decision-making of the investing public at large.

Now let’s look at the other side of the coin. Positive economic data points toward a recovery, which in turn means an unlocking of the U.S. credit market.

As you know, the supply of U.S. dollars has been expanded—by trillions of greenbacks—thanks to the various bailouts, Federal debt issuances and monetization, corporate and mortgage debt buy-backs and other assorted efforts to liquefy the U.S. economy. But relatively little of this new currency has been put to use: Monetary velocity—money at work in transactions—has remained moribund.

Think of it this way: A veritable ocean of fiat notes has been amassed, but this flood of money remains trapped behind a dam. Banks are risk-averse and reluctant to lend. Consumers are concerned that unemployment is still high and are reluctant to spend.

But if things start to look up, as they appear to be doing now, the dam holding back this ocean of money will burst.

That means inflation… which means a lower dollar and higher gold prices.

And here’s another way to think of it: We may be seeing only a tiny spark of life in the economy. But if that spark is enough to rekindle risk-taking by lenders and consumers it will be as if a bucket of gasoline is being thrown upon the budding flame.

And then, at some point, we’ll see the stimulus spending finally hitting the economy. As with nearly all government meddling in the free market, it will hit at the worst time… and throw more gasoline on the fire.

Keep in mind that I’m not predicting either the positive or negative scenario in the discussion above; I’m only explaining the thought process of the market right now.

So what do I think? Frankly, I’m worried about the next couple of months, as the stock market is discounting much better economic performance than we’re going to see anytime soon. It might not be pricing in “perfection,” but it’s definitely pricing in “pretty damn good.”

The slightest hiccup in the recovery will send the longs running for the exits, eager to capture whatever profits they’ve amassed on paper. This would likely precipitate a very significant sell-off in the U.S. and global stock markets.

That prospect aside, I do think that an economic recovery is beginning to take hold, both in the U.S. and in the economies of our major trading partners.

As you know, I noted last month in the article Gold Quietly Marshalling Strength that the recession here was technically ending, although there would be considerable economic pain still ahead.

So it appears we’re going to dance along a razor’s edge for the next couple of months.

Brien Lundin

is the editor and publisher of Gold Newsletter, a publication that has ranked among the world's leading precious metals and resource stock advisories since 1971. To learn more about Gold Newsletter, visit www.goldnewsletter.com. Mr. Lundin is also the host of the famed New Orleans Investment Conference, the world's oldest and most respected gold investment event. To learn more, visit www.neworleansconference.com.

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  • OldPhart

    You’re forgetting that China quietly built themselves a gold reserve and transferred their holdings to it from other nations. Also, China has been actively buying gold. http://www.usagold.com/amk/abcs-dragonshoard.html

    –China. Chinese official gold reserve holdings increased 75% in the spring, rising 115 tons to 267 tons.

    –Russia. Moscow also increased holdings, to a more modest 126 tons.

    China’s gold move came in the aftermath of the large fall in price from March 2008. Considering Beijing’s concern over the dollar, combined with the prospect for a gradual lifting of the renminbi’s value, further declines in the gold price are likely to bring back China into the market.
    http://www.forbes.com/2009/09/15/gold-rally-dollar-business-oxford-analytica.html

    There was a quote from a Chinese official from another link, however I can no longer find it. In effect the official said that China was actively buying gold but had to be careful because as they made purchases the price would rise dramatically.

  • Dave

    It sounds like Gold is a great investment, but as a newbie to buying gold, and not having the cash to buy a lot a gold, how do I invest with limited assets to spend on gold?

    • James

      Dave, Mr. Lundin needs to look at the long term. In 1999 gold bottomed at $250/oz. and now its at $1000/oz. That’s a 400% gain in ten years, a 40% gain per year. That doesn’t mean gold has become more valuable it just means the dollar has lost 3/4′s of its value. Gold is simply a storehouse of value. An ounce of gold always buys the same amount of corn, beans or wheat. I would recommend buying silver instead, it’s curently at $17.39/oz. and has a lot of catching up to do. On August 31st, silver was at $14.91/oz., that’s a 16% gain in 13 days of trading. I would buy 5 oz. silver bars, not coins, you just want the metal not the more expensive coin. Check in your phone book for local dealers in gold and silver bars. The smallest premium I’ve found is at Northwest Territorial Mint (1-800-344-6468), they have 1, 5 and 10 ounce bars.
      I say ‘silver’ rather than ‘gold’ because in 1933 FDR outlawed the possession of gold, and President Obama will probably do likewise. FDR is his hero.

  • DaveH

    Dave,
    How about Silver? I think it is actually a better investment right now. Being more of an industrial commodity than gold, it will benefit from an increase in economic activity as well as being a good protection against inflation. Silver would also be less vulnerable to a Roosevelt-style confiscation. You can easily buy small amounts of silver on Ebay. If that seems too risky (I think it’s pretty safe) then you can buy from a coin dealer (but pay more premium). Since silver is a much cheaper precious metal, you can buy in smaller amounts whenever you have some extra money and feel that the price is right.
    In any case (gold or silver) keep in mind that the main driver of price in precious metals is the value of the dollar. I say this because many people would think ‘How can the value of silver or gold go that much higher?’. The answer is that the value in constant dollars stays relatively stable, but in nominal dollars the price goes up because the value of the dollar is declining. If for instance the Federal Reserve created twice the supply of money, then the dollar’s value would be cut as much as 50%.

    • James

      DaveH, I agree. In 1933, Gold was $25/oz., now its $1000/oz. That’s a loss of 97.5% of the dollar’s value. Or stated otherwise, it takes $40 now, for what you could buy back then for $1. Then, if a kid found a penny in the street, he could buy a handful of candy with it. Now, most people don’t bother to pick up dimes, and it costs the federal government 1.6 cents to make a penny. Copper tubing companies could buy bags of pennys, melt ‘em back down and lower their cost of production.

  • s c

    A basic rule-of-thumb demands that people invest in that which has value and holds its value. In effect, it says much about the ‘value’ of the fading dollar. It also says much about those who preach ‘full faith and credit’ but practice wealth confiscation.
    What matters most is that people are thinking about keeping their wealth. Just because you can’t take it with you doesn’t mean that people are obligated in any way to make it easy for the government to steal it.

    • James

      SC, well said. A paper dollar has an intrinsic value of less than a penny. That’s true of any fiat currency regardless of its denomination. It costs no more to print a hundred dollar bill than a single. What paper dollars are worth is determined by the number of them that are in circulation, and let’s remember only about 2% of our dollars are actually printed up. The bulk are just electronic impulses on computers. When a bank fails and their computers are turned off the ‘money’ disappears. Gold, on the other hand, is eternal even if it has been on the ocean floor for centuries.

  • Bill Bos

    All:

    This talk about a gold standard and fiat money is nonsense. Gold is just another commodity. Its value is not constant. It cannot be used as a reference value standard like the freezing and boiling temperatures of water can be used for temperature scales. If you want to get your butt burned just go out speculate on it. You are competing with the pros and the cards are stacked against you.

    The thing that is being left out of the discussion is the basic economic law that product equals income. At any given time, there is just so much money in the economy and there are just so many goods for sale in the economy. The money is spent on the goods. In the bidding process of the market, the sum has to come out so that total value of the money is equal to the value of the goods.

    Essentially, the government introduces money into the economy by authorizing banks to make loans. (Note: it takes money out by taxing.) If they do this right, they will introduce money at a rate that will allow commerce to proceed. If they introduce it rapidly, the value of the money will decline. This is called inflation. If they introduce it slowly, the value of the money will increase. It becomes another commodity. It doesn’t make any difference what it is made out of.

    It makes no sense to dig gold out of the ground just to bury it in the ground again at Fort Knox. When the government does this, it is just subsidizing the gold miners and getting into the gold trading business. Perhaps an easier way to satisfy the money standard proponents would be for the government to print money certificates, hide them in the mountains and let the miners go out and find them. This makes just as much sense as a gold standard and does not expose the miners to the dangers of the gold mines.

    It is very important that the government handles the flow of money properly. In addition, how they handle it will benefit different political constituencies. For instance, they can increase the value of the money by introducing new money slowly. This sounds good, but consider the money lender or banker. Under these conditions, he has a strong incentive just to hold onto his money rather than lending it out. He can make money from the appreciation of his money at absolutely no risk. This situation usually results in a depression. If the government introduces money into the economy rapidly it loses its value over time. Under this situation, the banker has a strong incentive to loan out his money before it loses its value. If the money loses its value too rapidly, nobody wants it.

    In principal, this sounds like something easy to handle. In practice it is not. Under the Constitution, the Congress is charged with handling this. In practice, it takes great economic skill and must be handled under extreme political pressures from the competing special interests. The Congressmen found that they could not handle it. That was why they created the Federal reserve board to do it for them.

    It seems to me that the members of the Federal Reserve Board should all be well trained skilled economists. Bankers are one group of the special interests and should not be allowed to serve on the Federal Reserve Board. Any banker or other financier found within a mile of the Federal Reserve should be shot on sight.

    The Federal Reserve Board wields great power. They frequently have to make unpopular decisions. It seems to me they should be treated similarly to the way that we treat Supreme Court Justices. They should have life time salaries and never have any other payed employment.

    Currently, the Federal Reserve Board is charged with handling the money supply to minimize inflation. I think this is a mistake. Inflation is an automatic equalizing or correcting mechanism in the economy. Other more serious consequences can occur if it is not allowed to occur. Commerce coming to a halt is one of them. The aggressive efforts to control inflation in the recent past could be a major contributor to our current economic problems. Inflation will have to occur in the future to reduce the huge debt that we are now running up. I feel that a better charge to the Federal Reserve Board would be to manage the money supply so that commerce proceeds most efficiently.

    As I am finishing this, I notice in James’s reply to SC the statement:”Gold, on the other hand, is eternal even if it has been on the ocean floor for centuries.” This means that gold would be very good for boat anchors. It is no good as a monetary standard

    Sincerely,
    Wm. F. Bos, P. E.

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