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.