[Editor's note: This article has been revised since original publication, as the author erred in numbers representing the past decline rates of DJIA. Apologies for any confusion this may have caused.]
I published an article discussing gold's short-term bearish outlook and I would like now to focus on the long-term perspective that is extremely bullish.
The recent sell-off has created a very bearish outlook on the short term from a technical point of view. Indeed, by breaking the $1,500 support (it is a strong support, you can observe that this level of price has been tested several times since the historical high in September 2011), gold experienced a sharp reversal to the downside because a lot of stops around this strong support were triggered. As a result confidence in gold by investors has been shaken and it will take some time for the gold market to start a strong rally.
Nonetheless, this decline is in fact healthy because the small players who use too much leverage got wiped out and more and more stable entities such as long-term investors constitute the long positions in the market. In this regard, the World Gold Council has said that buyers are considering this sell-off as an opportunity to purchase gold at prices not seen in the past couple of years and a massive wave of physical gold buying has started during the plunge.
Finally, history has already proven that this type of sell-off is really likely during a bull market because it has happened before multiple times. For example, during the last bull market for gold (1970-1980), it fell by over 40% in 1975 and 1976 ($180/oz to around $100/oz) before surging by over 700% until 1980.
I am extremely bullish for gold in the long run because a major sovereign debt crisis in the future is very likely. Indeed it is purely a myth to believe that countries never default on their debt. In fact, countries routinely default. In their book This Time is Different, the authors Carmen Reinhart and Kenneth Rogoff counted more than 250 sovereign defaults since 1800. As Alex J. Pollock put it, "sovereign debt crises are inevitable because governments always promote government debt."
According to history, gold is an international safe haven and a good hedge against sovereign debt crisis. This can be explained by the fact that gold acts like just another currency. If the dollar (or the euro, the pound, the yen, etc.) is losing value against all the currencies, it will also lose value against gold and gold will appreciate (see the article by Fergal O'Connor, LBMA Bursar and Dr. Brian Lucey, Trinity College Dublin).
This is why gold will rise as it rose during the sovereign debt crisis that began in Europe in 1931.
Let's now analyze what happened from 1929 to 1936 regarding the US stock market (the Dow Jones), the US Dollar index and gold prices. As the United States was on a Gold Standard from 1900 to 1971 (except between 1933 and 1934 when Roosevelt took the United States off the Gold Standard by signing the Executive Order 6102 "forbidding the Hoarding of Gold Coin, Gold Bullion, and Gold Certificates within the continental United States"), gold's value was fixed by the government. As a result, in order to observe the real trends we will focus on gold stock prices instead of using gold spot prices. As Homestake Mining Company was one of the biggest mines during this period, we will use this stock to monitor gold prices.
Source: World Gold Charts @ chartsrus.com
Source: Princeton Economics
In 1929, the Dow Jones (DJIA) fell sharply from its peak value of 385 in October 1929. Gold prices were already declining from July 1929: a leading indicator of the coming deflation? To put this into perspective, while Homestake Mining declined from July 1929 to November 1929 by 30%, the DJIA fell by over 50% during this same period.
The acceleration of the decline in the DJIA was triggered by a new phase of deflation: the sovereign debt crisis in Europe. That phase started on May 6th 1931 when Credit-Anstalt, an Austro-Hungarian bank that was one of the most important financial institutions of the Austro-Hungarian Empire, revealed enormous losses on non-performing loans. The Austrian government backed the bank in order to restrain capital outflows, but that only led the speculators to doubt the Austrian government's credibility. As the French and Germans argued over the deal, no bailout for Austria was possible and so the country defaulted. The crisis then spread to Germany, Britain and France.
At first in 1931, the dollar surged with gold because Europe was collapsing so a "flight to quality" effect occurred as investors sold what they perceived to be higher-risk investments and purchased safer investments such as US Treasuries and gold pushing gold's price and the US dollar higher and the DJIA lower. The DJIA fell by about 55% in 1931 whereas Homestake Mining increased by about 50% and the dollar rose by 27% this year.
Then, in 1932, investors began to express fears about the soundness of the banking system in the US and government's credibility spread to the country. As a result, capital shifted from the US Treasuries pushing the US dollar lower. As gold was still viewed as an international safe haven, its price continued its upward momentum. Homestake Mining was up by 25% in 1932 whereas the dollar declined by 15% (and continue its plunge into 1933) and the DJIA plunged by 23% bottoming at 41 in June 1932 before starting a rally.
Finally, once the DJIA had finished collapsing both gold prices and the DJIA rose but the rally in gold was spectacular compared with the rally in the DJIA. Indeed, from 1933 to 1936, the DJIA rose from 60 to 180 - a 200% gain while Homestake Mining rose from $125 to $495 - a 296% gain.
We can clearly see that gold's attractiveness was due to sovereign debt problems.
To conclude, if you believe that "this time will not be different" and that Europe or Japan will experience a major sovereign debt crisis that will spread worldwide, Gold will be your best hedge against sovereign debt defaults.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.